Ozzie Mascarenhas SJ, PhD.
May 13, 2009
From an academic point of view, a business plan is a roadmap, a statement of strategy, an operational model, a business forecast or some other conceptual label. From an entrepreneur’s viewpoint, a business plan is a selling document, a sales pitch you give to prospective venture capitalists and banks. A business plan does not sell a product or a service or a work environment, it sells an entire innovation project, the entire business venture or your new company. If you are really excited about and believe in your project or your new company, it should reflect in the business plan. Excitement, however, is not based on puffery or exaggeration. It is based on supporting evidence in the form of solid research and experience. The innovation, new product or service idea that you sell or form a company about should be real, credible, convincing, promising, attractive, demonstrable, and worth investing to your stakeholders. Hence, have a clear purpose, content, audience and expected outcome for your business plan. These will generate a sense of commitment, focus and realism to your document.
A completed business plan is a guide that illustrates where you are, where you re going and how to get there (Charles J. Bodenstab). A business plan may tell you by the time you are done that this is not a profitable business. If you go into the business world without a path to walk down, without some sort of guidelines, you are in trouble (Geoff Walsh). The business plan could be the most useful and important document you, as an entrepreneur, ever put together. The plan keeps you thinking on target, keeps your creativity on track, and concentrates your power on reaching your goal (Megginson, Byrd, Scott and
Megginson 1994: 138).
A properly developed and written business plan serves as an effective communication tool to convey ideas, research findings and proposed plan to potential investors. The business plan is the basis for managing the new venture. It also serves as a measure to gauge progress and evaluate needed changes.
Gumpert (1997: 120-147) provides eight reasons for writing a good business plan:
1.
2.
It is a “sanity check” for you. Write your plan and run it through others for their response and reactions. Not all would agree with you and your plan. Nevertheless, agreements and disagreements will help you to focus better, sell yourself more credibly, and revise your assumptions and presuppositions.
To obtain Bank Financing: Getting bank finance is tough, and you will have to make a clear
3.
persuading case to your prospective bankers. Currently, (given the bank failures of the late 1980s and early 1990s), banks are under great scrutiny by federal regulators and, consequently, require entrepreneurs to include a business plan with any request for loan funds.
To obtain Investment Funds: A written plan endorses your belief and commitment to your business idea. Investors and the Securities Exchange Commission (SEC) want written business
4.
plans than mere oral presentations.
To arrange Strategic Alliances: Small and large companies need others and each other. Small companies need financial support and big companies need innovation. Besides obtaining funds, your business plan could ground joint research for developing your core product and competencies (front-end innovations) and joint marketing for bundling, promoting, retailing and servicing (backend innovations) your product.
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5.
6.
7.
8.
To obtain large Contracts: Your major buyers will not contract with you until they are convinced that your product meets with quality standards, and that you will stay in business for at least three to five years. A formal written business plan should convince them about these concerns.
Today, big corporations are looking for long-term supplier chain management (SCM) relationships.
To attract key Employees: Best talent normally looks for stable large companies. Hence, as a small business, your business plan must be able to attract good executive, engineering and blue-collar worker talent to your fledgling company. Good executive and engineering talent, tired of convoluted bureaucracies of large corporations, are seeking personalized, ethical, and empowering morale and climate of small companies.
T complete Mergers and Acquisitions: If your business plan intends a merger, acquisition, divestiture, technical collaboration, cross-licensing, strategic alliance or a joint venture, then your prospective business partner would like to know more about you and your venture from your business plan.
To motivate and focus your Management Team: A written business plan with clear short-term and long-term goals and strategies will enable your executives, engineers, marketers and workers to stay focused, motivated and productive.
A business plan has usually three parts: a) A Summary Business Plan (< 5 pages) containing executive summary on all the key points of your full business and operational plan. b) The Full Business Plan (10-20 pages) covering topics 1-14 below, and c) The Operational Business Plan (25+ pages) covering materials, purchasing, product design, production, inventory, sizing, packaging, bundling, costing, pricing, distribution, promotion and advertising, business forecasts, cash flows, and profitability.
The length, depth, breadth and technicality of your business plan would depend upon several factors:
1.
Nature of your business (its size, growth, complexity, newness);
2.
The domain of your business (local, statewide, regional, national, international, global and online);
3.
Size of the bank loans needed;
4.
Size of investor commitment expected;
5.
Size of your collateral; what you bring to the table;
6.
Strategic business partners (mergers versus acquisitions versus joint ventures versus alliances);
7.
Your credibility and fame as a seasoned and successful entrepreneur;
8.
The nature of your innovation (radical versus incremental);
9.
The nature of your breakthrough idea (market versus technological breakthroughs);
10.
The nature, complexity, cultural diversity, rarity and cost of the skills required for your business;
11.
The nature of the target markets (old versus augmented versus new markets),
12.
The size, stability, volatility, potential and accessibility of your target markets;
13.
The risk, uncertainty and ambiguity of your products and target markets; and
14.
The legal implications of your products or services (e.g., safety, security, privacy, unions, patents, intellectual property, and OSHA, CAFÉ, EPA, USDA, SEC, CPSC or WTO regulatory requirements).
1.
Cover page: Name of the company, address, name of the president or contact person with phone,
Website and email details. The cover page should also include copyrights.
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2.
Table of Contents: Provide Contents in brief, and Contents in details. Some bankers read portions of your business plan picking items from the Table of Contents.
3.
Executive Summary: This is the business plan in miniature. It should catch the excitement and essence of the business. This is the single most important section of your business plan because most of your target audience will start reading the summary first before digging into the Business Plan proper. Your executive summary has to keep potential investors, bankers or venture capitalists interested. If you lose them here, you lose them forever. It should rarely exceed two pages of bullets.
You may write this first before you start working on the business plan, or you may do it at the end.
In any case, this piece of the business plan should get your best attention, skills, drives and passion.
4.
The Company: What is your corporate identity? Provide your company’s history in brief, your start-ups, your current business strategy, management team, and a record of accomplishment of past products and successes (and failures). In describing your business strategy, tell the audience what you plan to do, but follow it carefully in the subsequent documents. Make your business strategy relevant, credible, doable, believable, and logically consistent. In this connection, analyze your past successes and problems as honestly and objectively as possible, with both its positive and negative aspects, describe your current status (e.g., its feasibility, viability, sales and earnings trends, your product and marketing mix, significant changes and profitability. Thirdly, outline your future goals, how they continue or depart from the past, why, and with what success. Describe your management team and how it is geared to realize your future goals.
5.
The Market: Who are your target market or potential buyers? How and why did you identify them?
What was your market scanning, market research, and market forecasting on this? What is your customer base, customer prospects, and how best can you reach them. What are your target market demographics and possible demographic shifts? Detail on the size, accessibility, stability, buying power, volatility of the target market. What will make the market believe and buy- in your product?
Is your market growing or shrinking, stagnant and stale? How do you plan to protect this market by suitable and ethical market entry barriers?
6.
The Product/Service: What are you selling? To whom? Why? How? When? Where? Through whom? How often? Describe your creation/innovation/invention/discovery product or service with its essential features and attributes, values, costs and benefits, quality and utility to the target markets.
How can your product fulfill unmet needs, wants and desires of your target customers? What convenience and saving (of time, money, energy, effort, anxiety, space and pace) does your product provide that your competition does not? Quantify your costs and benefits to the prospective customer.
7.
The Production Phase: Describe the essential ingredients, materials, components and parts required for the production of your product/service. Describe your suppliers, your purchasing strategies, your materials inventory, your in-process inventory and your finished goods inventories. Foresees problems and resolution of design, manufacturing, platform technology, patents and intellectual property, scale and scope economies, sizing, bundling, packaging, transportation logistics, costing and pricing, and other factory problems.
8.
Sales and Promotion: Detail on your marketing, advertising, promotion and distribution plan and strategies. In-house versus external marketing consultants. Detail your promotion tools such as price bundling, product bundling, price and product hybrid bundling, warranties, guarantees, discount pricing, rebates, credit, financing, product expansion and updates, and refund and recall policies. What are your plans for Web-marketing, Website designs, Web-auctioning, Webpersonalizing, and other modern Internet marketing strategies? What are your selling plans, costs and strategies? What are your retailing plans, costs and strategies? What are complaint handling and redress strategies? How will you motivate your distributors, retailers and sellers? How will your corporate advertising, PR, brand image building, product preannouncements, and brand community-building supplement and support your selling, retailing and distribution strategies?
9.
The Competition: Unless your product is absolutely new to the world, it will have competing brands, substitutes and surrogates. Examine and assess them. Who are your competitors, their products or services, their quality and brand equity, their price and rebate offerings, their price and product
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bundling, their warranties and guarantees, and their credit and financing strategies? Be sure, you cover international and global competition if relevant. How would your establish sustainable competitive resource advantage (SCRA) against this competition? How would you establish your sustainable competitive quality advantage (SCQA) against this competition? How would you establish your sustainable competitive marketing advantage (SCMA) against this competition?
10.
Finances: What are your costing, pricing, break-even and mark-up plans? What are your premium, penetration and competitive pricing strategies? Based on your business forecasts, project your cash flows, cash outflows, cash inflows, net cash flows, for the first, second, third, fourth and fifth years.
Study your cost of goods sold (CGS), selling and administrative costs (SAE), capital expenditures, interest expenses, owning versus leasing versus renting expenses, depreciation, wage payrolls, taxes, gross margins, contribution margins, net earnings, retained earnings and dividends. Hence, also project ROQ, ROS, ROM, ROE, ROI, ROA, and EPS, P/E, and TSR if publicly traded.
11.
Concluding Remarks: Summarizes your strengths and weaknesses, threats and opportunities, unique features and attributes, great values and benefits to make a final and brilliant pitch to your reader audience.
12.
Appendices: This is the place for executive and team résumés, product literature, patent literature, endorsement letters from suppliers and customers, and the like.
Table 4.1 summarizes the content of a business plan and the relevant questions you should ask under each item.
Before embarking on any business project, it is critical that you ask the right questions and explore focused answers on several key issues. For instance, examine your current financial position by answering some simple questions (Blaney 2002:57): a) Where are you now? Do you have the money to start this business? Do you need to borrow from banks? Do you want to attract venture or angel capitalists to your project? What is your current business status: Are you insolvent: that is, can you pay all your bills and debts when they are due?
Do you have sufficient cash for the immediate near future? Will the banks (assuming you have bank borrowing capacity such as overdraft) bail you out? b) How did you get here? What brought you to your current business status? Do you have in the immediate any negative net cash flows? What was your business performance record of accomplishment with immediately past innovations and new product introductions? c) Where are you going from here? What are your longer-term cash, sales, profit and loss, balance and security forecasts? How did you forecast? How objectively and realistically did you forecast?
Presumably based on your forecasts, how and why did you set your targets? d) How do you know now that you will reach there (your targets)? How would you know that you have reached there? What are your metrics to gauge your performance? If you do not reach your forecasted targets, what is your risk? What is the impact of such a risk on your profits and financial performance ratios?
If you are in a cash crisis (first question), then you should not worry about the past (second question) or about your future (third and fourth questions). Your business plan should address all four questions: with sales, CGS, receivables, payables, inventory, cash, cash cycle, cash flows, cash flow forecasts, cash flow statements, cash flow management, cash budgeting, harvesting cash, and anything about cash that will help you answer the first and the third questions and get you out of a cash crisis. The single most
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important tool for building new companies or saving dying ones is the deft management of cash flow
(Wexler 2002).
Often, new products turn out to be cash traps . Bruce Henderson, the founder of the Boston
Consulting Group, warned managers over three decades ago: “The majority of products in most companies are cash traps. They will absorb more money forever than they will generate.” Most new products (almost 5 to 9 out of ten products) do not generate enough cash or enough financial returns despite massive investments in them. For instance, Apple Computer stopped making the striking G4
Cube less than a year after its launch in July 2000 as the company was losing too much cash on the investment. Proctor & Gamble in 2002 made half of its sales and even a bigger share in profits from just
12 of its new 250-odd products of that year (Andrew and Sirkin 2003: 77). Creativity and innovation are not enough. There is a big difference between being innovative and an innovative enterprise: the former generates many ideas; the latter generates much cash (Levitt 1963). A failing company needs innovations that turn into good markets and good markets that turn into good cash and financial returns – this is the innovation-to-cash chain (Andrew and Sirkin 2003: 78).
A key question we ask before any business decision or undertaking is: Will the decision create value for the firm’s owners? The fundamental finance principle responds to this question stating: A business proposal (e.g., new investment, acquisition, merger, a restructuring plan) will raise the firm’s value only if the present value of the future stream of net cash benefits the proposal expects to generate exceeds the initial cash outlays required to carry out the proposal (Hawawini and Viallet 2002: 5).
The present value of the future stream of net cash benefits the proposal expects to generate is the amount of dollars that makes the firm’s owners indifferent between receiving that sum today and getting the expected future cash-flow stream. For example, if the firm’s shareholders are indifferent between receiving cash dividend of $100,000 today and getting expected cash dividend of $110,000 next year, then $100,000 is the present value of $110,000 expected next year. That is, the shareholders expect to receive a return of 10 percent from the project, which is called the discount rate (the rate at which the future cash flow must be discounted in order to find its present value). A proposal’s appropriate discount rate is the cost of financing the proposal. By the fundamental finance principle, a project is undertaken if its net present value (NPV) is positive (i.e. it creates value for the firm’s owners), and is rejected if its
NPV is negative (since it destroys value for the firm’s owners). This is called the
Net Present Value Rule .
The fundamental finance principle requires that the initial investment needed to undertake a proposal, as well as the stream of net future benefits it expects to generate, be measured in cash . Only cash matters to the investors, whether they are shareholders (providing equity capital ) or debt-holders (leveraging debt capital ) because all they have invested is cash in the firm and are expecting cash returns in the future.
[Note that the cash benefits of a project are not the same as the project’s net profits – the latter are accounting measures of benefits, not of cash returns].
In 1993, Dell experienced a serious liquidity problem. Dell’s rapid growth coupled with poor working capital management was rapidly stifling their ability to grow in the future. In order to remedy the problem, Dell institutionalized a working capital program that focused on cash flow and a more efficient cash management process. Today, working capital management is part of the Dell fabric and
DNA for growth (Hartman 2004: 150).
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How to use cash is the biggest issue in an ongoing restructuring plan. Debt and cash are two top priorities in troubled organizations, especially those that have no choice but restructure. Some corporations use cash to buy back their own stock, especially if there is no other better investment opportunity. Others pay dividends giving cash back to shareholders and assuring them that they can think of no better investment for their money. If you restructure your balance sheet to reduce your debt in profitable times, you prepare yourself for times you will need to raise the debt. Excessive debt creates unremitting pressure from financial and trade creditors. Financial creditors harass management about delayed interest payments, violated debt covenants, sinking fund obligations and early repayment schedules, and may even threaten to deny the company further credit. Trade creditors warn the struggling company about overdue balances and may threaten to withhold further shipments. Controlling your cash and cash flows are very important in satisfying both your financial and trade creditors (Pate and Platt
2002: 92-3).
We can view a satisfied customer as an economic asset that yields predictable future cash flows
(Fornell 2002: 41). Satisfied customers are more loyal and increase their level of purchasing over time
(Anderson and Sullivan 1993; Reichheld 1996), are more receptive to cross-selling efforts (Fornell 1992), are less likely to switch to competing brands despite their alluring lower prices (Fornell et al. 1996), and generate positive word-of-mouth patronization (Anderson 1996). All these factors contribute to steady and enhanced future cash flows that ensure higher shareholder value.
In order to appreciate fully the critical importance of cash and cash flows to any business, we first define some major terms involved such as cash, cash flow, cash flow management, cash flow time line, operating cycle, cash cycle, cash flow management measures and cash flow statements. Most of these terms follow generally accepted accounting principles (GAAP).
Most familiar to us as the term “cash” is, it is a surprisingly imprecise concept. From a banker’s viewpoint, cash is money or any medium of exchange that a bank accepts at face value . Cash includes currency, coin, and funds on deposit that are available for immediate withdrawal without restriction. Cash is the first current asset listed on the balance sheet of most companies. A balance sheet lists all assets in relation to their degree of liquidity. Cash obviously tops the list in the balance sheet as being the most liquid monetary asset of the firm. The cash account on the balance sheet is the amount of liquid assets available for the company’s day-to-day uses.
The economic definition of cash includes currency, money orders, certified checks, cashier’s checks, personal checks and bank drafts, checking account deposits at commercial banks, and un-deposited checks. Financial managers use the term cash also to include short-term marketable securities. Shortterm marketable securities are short-term investments with a maturity not exceeding one year.
One property of liquidity is divisibility , that is, how easily an asset can be divided into parts (Ross,
Westerfield and Jaffe 2002: 771). The economic definition of cash is based on liquidity: currency, checking accounts at commercial banks and un-deposited checks are highly divisible into small units and usable to pay bills. As the most liquid of all assets, cash is also the medium of exchange for assets and liabilities. It serves as a basis for measuring the value of all assets and liabilities.
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The balance sheet term “cash or cash equivalents” reflects the amount of money or the currency the firm has on hand or in bank accounts. Cash equivalents are short-term and highly liquid investments readily convertible into known amounts of cash and close enough to maturity. Typical cash equivalents are short-term marketable securities such as short-term U. S. Treasury bills issued by the government, certificates of deposit issued by the banks, commercial paper issued by corporations with good credit ratings, shares in money market funds , and repurchase agreements . The balance sheet item “cash” usually includes cash and cash equivalents. Net working capital includes both cash and cash equivalents.
Cash equivalents are highly liquid; that is, one can easily sell or convert them to cash with minimal change in value.
How is cash amount measured? If cash consists exclusively in US dollars, the balance sheet account reflects the historical amount of net dollar units arising from past transactions. Since cash is very liquid, this historical amount of net dollar units is identical to the current market value of the cash.
If a firm is multinational, and some cash is in foreign currencies, then the foreign currency units must be translated into U. S. dollar equivalents. For some monetary assets like cash, accounts receivable and notes receivable, the current rate of foreign exchange (in effect at the balance sheet date, and not the historical rate of exchange that was in effect at the time of the foreign currency cash inflow) is used to translate foreign currency into U. S. dollars. Some currency conversions involve conversion commissions or exchange fees. Thus, this foreign portion of the cash account is carried at its current market price, irrespective of whether it is higher or lower than the historical rate. Thus, for foreign accounts, the GAAP measurement convention for cash is market price rather than historical cost (Revsine, Collins and
Johnson 1999: 109-110).
There are two primary reasons for holding cash:
1.
For transactions such as disbursements and collections. Disbursements of cash are cash outflows and include the payment of wages and salaries, rents, utilities, shipping, trade debts, taxes, and dividends. Collections of cash are cash inflows and occur from selling products and services, sales of fixed assets, income from investments, royalties from patents and licenses, and new financing.
2.
For Compensating balances: minimum cash balances are held in commercial banks to compensate for banking services provided by them.
Since minimal compensating balances must be maintained in order to obtain banking services and not for transactions, the cash of most firms can be thought of as consisting only cash holdings for transaction balances. The cost of holding cash is the opportunity cost of lost interest. To determine the optimal cash balance, the firm must weigh the benefits of holding cash against opportunity costs of lost interest and cash-shortage. Many firms hold very large balances of cash and cash equivalents. For instance, in 1997, the largest cash balances included those of Ford ($18.5 billions), General Motors ($10.1 billions),
Microsoft ($9.1 billions), Intel ($8.5 billions) and IBM ($6.5 billions). The reasons firms hold large balances of cash and cash equivalents include precautionary needs such as a recession, large anticipated spending on dividends, stock repurchases, privatization, stock options, or capital investment.
Financial Statements are formal documents issued by firms to provide financial information about their business and financial transactions. Regulatory authorities (e.g., GAAP, SEC) and stock markets, in which their shares are traded, require such financial statements at least annually. Two primary financial statements include: a balance sheet and an income statement (the latter is also called the profit and loss
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statement or P&L account). In some cases, regulatory authorities also require a third protocol: a statement of cash flows, which provides information about the cash transactions between the firm and its outside world. Financial statements are mostly meant for the investors who are the primary users of such statements. Hence, these statements must use terms and expressions that are commonly employed in financial accounting and must conform to general standards and rules, which in the USA are known as generally accepted accounting principles (GAAP).
The fundamental objective of a balance sheet is to indicate the value of the net or cumulative investment made by the firm’s owners (investors or shareholders) in their firm at a specific date, generally at the end of the accounting period. The balance sheet informs what shareholders collectively own and what they owe at the date the statement is made.
The fundamental objective of the income statement is to measure the net profit (or loss) generated by the firm’s activities during a specific period called the accounting period (or the fiscal year). The income statement informs the investors about the firm’s activities that resulted in increases (or decreases) in the value of the owners’ investment during a given accounting period. That is, the income statement or the net profit or loss statement is a measure of the change in the value of the owners’ investment in their firm during a given accounting period. Table 4.2
presents a sample of Projected Income (Profit & Loss)
Statements 2007-2010. Table 4.3
is a sample of Cash Flow Projections 2007-2010, and Table 4.4
describes a typical Pro-forma Balance Sheet.
Further, accountants who prepare the financial statements generally provide “ notes ” that provide additional information about the statements, such as their nature and the way they have been valued.
Also, firms prepare two sets of statements, one for financial reporting purposes and one for tax purposes.
Only the first set of statements (i.e., the balance sheet, the income statement, and the statement of cash flows) is public. These statements are found in the annual report that the firms publish every year.
Tables 4.5
and 4 .6
present financial statements, the balance sheet and income statement, of a fictitious
XYZ Manufacturing Corporation for the fiscal year ending on June 30 of 2003 and of 2002.
As stated earlier, the main purpose of a balance sheet is to provide an estimate of the cumulative investment made by the firm’s shareholders at a given point in time. This investment is known as owners’ equity . Other terms used for owners’ equity include shareholders’ equity, shareholders’ funds, and bookvalue of equity, net worth, and net asset value. Owners’ equity is the difference, at a particular date, between what a firm’s shareholders collectively own, called assets (such as cash, cash equivalents, inventories, receivables, equipment, buildings), and what they owe, called liabilities (such as short term debts and long term debts owed to banks, bondholders and suppliers). That is, according to the fundamental accounting principle of balance sheets:
Owners’ Equity = Total Assets – Total Liabilities, or, Total Assets = Total Liabilities + Owners’ Equity.
The balance sheet in Table 4.5
verifies this equation for two consecutive years of reporting, 2002 and
2003, as shown in Exhibit 4.1
.
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XYZ’s
Accounting period
Ending June 30,
2002
Exhibit 4.1: Verifying the Fundamental Accounting Principle at XYZ
Total Assets
$2,992,500
Total Liabilities
Owners’ Equity
Total Liabilities +
Owners’ Equity
$1,855,000 $1,137,500 $2,992,500
Ending June 30,
2003
$3,675,000 $2,310,000 $1,365,000 $3,675,000
That is, a firm’s total assets must have the same value as the sum of its liabilities and owners’ equity.
Owners’ equity is a residual value – that is, it is equal to whatever dollar amounts are left after deducting all the firm’s liabilities from its total amount of assets. If total liabilities far exceed total assets, owners’ equity is negative and the firm is technically bankrupt.
Fixed assets or non-current assets, also called capital assets, are assets that are expected to produce economic benefits for more than a year. Fixed assets are of two types: tangible assets (e.g., land, buildings, machines, and furniture, collectively called property, plant and equipment ) and intangible assets (e.g., patents, trademarks, copyrights, intellectual property, long-term relationships, brand community, brand equity and corporate goodwill).
Tangible assets are generally reported at their historical cost , that is, the price the firm paid for them when they were bought. As time passes, the value of the fixed assets (except land) is expected to decrease during their expected useful life. This periodic (usually, annual) and systematic value-reduction process is called depreciation , and noted in the balance sheet as depreciation charges or simply, depreciation. Two common methods of depreciation used are a) straight line depreciation method (assets are depreciated by an equal amount each year of the expected lifetime of the asset), and b) accelerated depreciation method (depreciation charges are higher in the earlier years of the asset’s life and lower in the later years. The total amount that is depreciated is the same regardless of the depreciation method used.
The value at which a fixed asset is reported in the balance sheet is its net book value . If the firm uses historical value or acquisition cost principle to value its fixed assets, then the net book value of the fixed asset is equal to its acquisition price minus the accumulated depreciation since the asset was bought. If the firm uses replacement cost principle to value its fixed assets, then the net book value of the fixed asset is equal to the price the firm must pay at the date of the balance sheet to replace that asset minus the amount of accumulated depreciation. Exhibit 4.2
illustrates the net book value under various depreciation methods.
In Exhibit 4.2
, we assume that an asset bought at an acquisition price or historical cost of $600 has a useful life of three years and its replacement cost the year it was bought is $750. Under the straight-line method for depreciation, we depreciate the asset each year by $200. Under accelerated method of depreciation, we depreciate the asset by 50% ($300) the first year, one-third the cost ($200) the second year, and one-sixth ($100) the third year. In Exhibit 4.2
, we assume the straight-line method for depreciating the replacement cost of $750, and hence, each year the depreciation amount is $250. Under each method, the net book value is acquisition cost (gross value) minus the accumulated depreciation.
Exhibit 4.2
illustrates that a fixed asset value reported in the balance sheet can have a different net book value depending upon the historical or replacement cost principle and the method of depreciation used. In comparing the financial performance of firms, therefore, one must check (from the “notes”) the cost
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principle and depreciation method used. Very few firms in the USA use the replacement cost principle; it is common, however, in the Netherlands (Hawawini and Viallet 2002: 44-47).
Depreciation is a component in cash flow adjustments (CFA). CFA = Depreciation + Net cash +
Proceeds from asset sales or divestitures – Capital replacement expenditures - Investment in growth capital expenditures [see Exhibit 4.3
].
Exhibit 4.2: Net Book Value under Various Depreciation Methods
Value Item
Year of Reckoning
Straight-Line Method Accelerated Method Replacement Cost &
Straight-Line Method
Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Year 1 Year 2 Year 3
Gross Value
(Acquisition cost)
Annual Depreciation
Charge
Accumulated
Depreciation
Net Book Value
$600
$200
$200
$600
$200
$400
$600
$200
$600
$600
$300
$300
$600
$200
$500
$600
$100
$600
$600
$250
$250
$600
$250
$500
$600
$250
$750
$400 $200 $0 $300 $100 $0 $350 $100 -$150
Assets are divided into two categories: current assets and fixed (non-current) assets. A typical balance sheet lists its assets in decreasing order of their accounting liquidity
– where liquidity is measured by the ease and speed at which you can convert assets into cash at a fair price. Thus, cash, which is the most liquid of assets, is listed first. Land and building, the least liquid of assets, are listed last.
Analogously, liabilities are listed in increasing order of maturity , where maturity is a measure of the time before the liability is due. Thus, short-term liabilities are listed first and long-term liabilities are listed last. Liabilities are also divided into two categories: current liabilities and non-current liabilities.
Owners’ equity is listed last, as it does not have to be repaid because it represents the owners’ investment in the firm.
Assets and liabilities are usually assessed and recorded according to the conservatism principle , which states: when in doubt, report assets and liabilities at a value whereby you would be least likely to overstate assets or understate liabilities. The recent legislation, the Sarbanes-Oxley Act of 2002 , reaffirms the conservatism principle (see Chapter One ).
Current assets are cash and other assets that the company expects to convert to cash within a year.
Usually, current assets include four major items: cash, marketable securities, accounts receivable, and inventories.
Prepaid expenses recorded on a balance sheet (e.g., prepaid rent, prepaid lease, prepaid payroll, prepaid taxes) are payments made by the firm for goods and services it will receive after the date of the balance sheet. A typical example is prepaid insurance, a payment for an insurance policy that will provide protection for a period of time that extends beyond the date of the balance sheet. A typical income statement records prepaid expenses by a key accounting principle, called the matching principle .
This principle states that expenses are recognized (in the income statement) not when they are paid but during the period when they are consumed or when they effectively contribute to the firm’s revenues.
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That is, expenses prepaid by the firm must be carried in its balance sheet as an asset until they become a recognized expense in its (future) income statement. For instance, in Table 4.5
, the prepaid rent of $5,000 for June 30, 2003 represents the rent for the year 2004 and thereafter. Often, these items are declared as prepaid expenses for tax purposes.
Current liabilities are short-term debts or obligations that the company must clear with cash within a year. Normally, current liabilities list four major items: accounts payable, notes payable to the banks
(also called short-term debt), accrued wages and other expenses payable and accrued taxes payable. See
Table 4.5
. Short-term debts include overdrafts, drawings on lines of credit, short-term promissory notes, and portion of long-term debt due within a year of accounting.
Working capital is current assets minus current liabilities. For XYZ it was 1,592,500 - 595,000 =
$997,500 for 2002 and 2,100,000 – 1,050,000 = $1,050,000 for 2003, an improvement of $52,500
(5.26%) over 2002. Thus, other things being equal, a significant increase of working capital for 2003 over 2002 indicates that XYZ is a healthy company in relation to cash flows and cash flow management.
Working Capital Management is improving working capital.
Fundamentally, managing working capital is a way to increase returns to the company; it allows one to increase cash flow used for investment (Hartman 2004: 149). Opportunities for working capital improvement differ across industries, but they typically involve controlling key business processes such as inventory, accounts payable and accounts receivable. Increasing working capital, however, is not an end in itself. Some companies that insist on JIT (e.g., Dell), payment on consignment (i.e., Wal-Mart pays its retailers only when their products are sold and cash is realized) and cross-docking inventory systems (e.g. Wal-Mart), may even show negative working capital, and still would have grown significantly.
Cash flow represents the available cash to pay current expenses. Cash flow is a value equal to income after taxes plus non-cash expenses. In capital budgeting decisions, the usual non-cash expense is depreciation. The management of working capital deals mainly with cash, receivables, payables, and inventories. A positive cash flow meets all current expenses. A negative cash flow implies more expenses than revenues; it forces short-term borrowing to meet your current expenses. Positive cash flows are not profits, just as negative cash flows are not losses. A positive cash flow is just cash after paying the costs (but not after depreciation). A negative cash flow is like bleeding; it is borrowing from
Paul to pay Peter.
Mere growth in sales does not assure a steady cash flow, as much of the sales could be tied in credit.
That is, sales may generate accounts receivables in the short run but no immediate cash to meet maturing obligations. Similarly, a high growth in sales with low profits can also create a cash crunch, especially if assets have simultaneously grown to generate the high sales growth. For instance, the sales in a given year might have doubled from $100,000 to $200,000, but if net profits are low (say 5% of sales, that is,
$200,000 x 0.05 = $10,000), and if assets have grown from $50,000 to $75,000 during the same year, then the net profits of $10,000 are inadequate to finance the additional assets of $25,000 unless one borrows the required amount ($15,000) from banks, suppliers or stockholders. In general, profits alone are inadequate to finance significant growth, and in which case, a comprehensive financing plan or forecasting must be developed. A cash budget is an important component of a comprehensive financing plan.
A cash budget is a series of monthly or quarterly budgets that indicate cash receipts, cash payments, and the borrowing requirements for meeting capital expenditures. It is normally constructed from the pro forma income statement and other supportive schedules.
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Cash outflows and inflows are not perfectly synchronized or certain, and some level of cash holdings is necessary to serve as a buffer. Figure 4.1
sketches various cash inflow and cash outflow items to create short-term net cash flows. If the firm maintains too small a cash balance, it may run out of cash for necessary transactions, and then, the firm must sell marketable securities or borrow, and both transactions involve trading costs.
Notice that XYZ’s cash balance remained constant at $175,000 during 2002 and 2003 (see Table 4.5
), even though cash flow from operations (that is, net income plus depreciation, the two major items that finally affect cash) was (259,000 + 105,000) = $364,000 (see Table 4.6
under the year 2003). Its cash remained the same simply because the sources of cash were equal to the uses of cash for the year 2003 as is demonstrated in Table 4.7. For instance, XYZ derived a major source of cash from net profits
($259,000) and depreciation ($105,000) for 2003, totaling to $364,000.
Another source of cash was increase in accounts payable by $87,500 – this is same as increased borrowing from suppliers. The notes payable increased by $350,000 from 2002 to 2003 – this represents increase in borrowing from the banks. Small amounts of cash were sourced, $8,750 in each case, from wages (i.e., withholding wages or benefits from the employees) and taxes payable (in effect, this is borrowing from the IRS). Thus, total sources of cash inflows for 2003 amounted to $819,000.
This increase in cash was spent on machinery and plant ($245,000), on dividends ($31,500), on prepayments and deferred charges ($35,000), on additional inventory of $345,000, in additional accounts receivable of $140,000 (this is equivalent to lending customers or granting credit), in purchasing $17,500 worth of marketable securities, and prepaying rent of $5,000 – totaling uses of cash (outflows) to
$819,000.
Hence, the sources of cash (inflows) were exactly used by uses of cash (outflows), with no net cash increase from 2002 to 2003. This case illustrates the difference between a firm’s cash position on the balance sheet and cash flows from operations. We will resume discussion on cash flows when we derive cash flow statements of XYZ Inc.
Cash flow management relates primarily to short-term financial decisions than to long-term ones, the latter being capital budgeting, dividend policy or capital structure. Short-term finance is an analysis of decisions that affect current assets and current liabilities, and their impact on the firm is normally felt within the year. The term, net working capital (current assets – current liabilities) is often associated with short-term financial decision-making. Short-term finance involves cash inflows and cash outflows within a year or less (e.g., ordering raw materials, paying in cash, goods are produced and sold, and salesrevenues are received in cash within a year). That is, cash flows management relates to short-term liquidity : an organization’s ability to meet current payments as they become due. Long-term financing relates to purchases, use, and revenue streams that roll over many years: e.g., a costly machinery or technology license bought this year, paid in five annual equal installments, and used for production that will increase cost savings over the next five years that, in turn, will more than cover the cost of the machine or technology license. Long-term financing relates to long-term solvency – that is, an organization’s ability to generate enough cash to repay long-term debts as they mature.
Cash flow management refers to valuable accounting information that includes product-cost data (i.e., how much labor, material and overhead are used in each product line and each product unit), break-even data (on fixed and variable cost), and a variance analysis that looks for efficiencies and inefficiencies by
12

comparing actual costs against industry standards. Cash flow management also includes a cash budget: this describes the expected inflows and outflows of cash that is used for wages, supplier outlays, and receipts from customers, bond and interest payments, dividends and the like. Conversely, a recovering company has to concentrate more intensely than ever on managing its cash flow and working capital.
Because in almost all turnarounds a cash crunch is well nigh inescapable, dealing with it becomes very critical for the turnaround. Cash can come from only two sources:

Internal sources: (e.g., cash equivalents, accounts receivables, acceleration of receivables, turning receivables into cash, forgiveness, conversion or extended terms for payables, inventory management, converting inventory to cash, asset restructuring, selling fixed assets, divestitures, and converting assets to leases).

External sources (e.g., banks, asset lenders, trust receipts, field warehousing, intermediate debt financing, venture capital, public issues, mergers, sellouts, and using loss carry-forward).
For an effective business turnaround, each item of the internal and external sources must be managed efficiently, effectively and quickly, and without much damage done to any stakeholders such as the suppliers, banks, retailers, distributors, employees and the customers.
Cash Forecast : Running out of cash is not an abstraction. Any day checks could bounce, receivables can become bad debts, and short-term payables may be due. Hence, daily cash projections, if possible, are best. Weekly projections are the next best choice. Biweekly projections are an absolute requirement
(Whitney 1999: 36). Difficult as it may seem, the turnaround leaders would have to make their cash projections, preferably short-term rollout cash forecast of at least 120 days, during the first week or ten days of their term. Since a cash projection is a reflection of countless operating decisions, there could be errors in one’s projections, but some information is better than no information at all (Whitney 1999: 37).
The first element of a successful turnaround plan is accurate cash forecast based upon receipts and disbursements. Good cash management works by actively managing and deciding about each of the line items of your weekly, or even daily, receipts and disbursements. This will bring costs in line with declining revenues. Most companies plan on a five-year forecast. However, if your long-range projections indicate the company will run out of cash within nine months, change your planning horizon to months, or even weeks or days if the crisis becomes near-fatal (Alix and Ramaekers 1995).
Cash flow is not depreciation added to the bottom line of an income statement. Nor is it looking at the balance of cash in the bank and developing a picture of how much cash will be there next month based on net income this month. Forecasting cash is an important ingredient of cash flow management.
Seventy percent of companies with revenues exceeding $50 million forecast cash. That percentage declines as companies become smaller, to the point where only 25% of companies with revenues of $10 million or less forecast cash (Kort 1999).
An income statement is not a good barometer of a company’s financial well-being, even though an income statement budget for the next year may set goals for revenue and profitability by providing benchmark for performance. Moreover, managers or accountants can manipulate the numbers on an income statement to obtain figures that please banks and security analysts. In such cases, earnings report the desires of management rather than the underlying financial performance of the company.
Income statements and budgets do not provide management with information on issues that affect cash flows, such as the collection of receivables or the adequacy of cash flows to cover debt payments or equipment purchases. These issues often translate into dramatic differences between profits and cash
13

flows. Managing a company by looking at past profitability (as judged from an income statement) is reactive. Managers must be proactive if they want to look at what lies ahead. One critical item that can help them in this regard is cash forecast. Figure 4.1
includes most of the major cash inflow and cash outflow items where a good controller could do the cash forecast for each year.
Studies have shown that cash flows from operations are a better predictor of financial well-being than income statements because it is much harder to manipulate cash flows. When comparing healthy companies to those involved in a turnaround, financially sound companies tend to have the ratio of net income (excluding depreciation) to cash flows from operations as 1/1 over a period of five years and more. Companies in financial trouble have such ratios also well exceeding one over one owing to fraudulent overstatement of income. For example, one company reported net income over a five-year period of several million dollars. Yet, cash flow during that period was less than $9,000, and the resulting ratio of net income (excluding depreciation)/cash flows from operations was 293 over a five-year period.
The company was in serious trouble. No one at the company, however, noticed this because they focused attention on net income as an indicator of financial health.
In a business turnaround situation, most cash flow metrics are sensitive to what the lenders or creditors, secured or unsecured, can claim from a company’s net cash flows. Secured lenders’ claims on cash flows precede those of federal taxes (Tax-Trust funds and payroll taxes), state taxes (income taxes and UIA [Unemployed Insurance Agency] taxes) and equity investors. Thus, the critical question is what the lenders are entitled from a company’s net cash flow, and what the company can legitimately deduct from its revenuers before paying its lenders.
Each operating cash flow formula must adjust for: a) depreciation tax shields, b) loan amortization tax shields, c) interest expense tax shields, d) federal corporate tax rates, e) state corporate tax rates and f) net operating losses (NOL) carry forward tax shields. Additionally, operating cash flows should reflect CFA
= Cash flow adjustments = Depreciation + Net cash + Proceeds from asset sales or divestitures – Capital replacement expenditures - Investment in growth capital expenditures for a given year. Exhibit 4.3
lists some of the common Alternative Discounted Cash Flow Valuation Methods .
(earnings before interest, taxes, depreciation and amortization)
is one useful but crude measure of pre-interest, pretax, pre-depreciation and pre-amortization cash flow. It is a crude measure of cash flow because although it is calculated before two key non-cash expenses, depreciations and amortization, it does not adjust for other non-cash items such as changes in working capital accounts.
EBITDA differs from the cash flow from operations found on the Statement of Cash Flows if you ignore payment for taxes or interest. EBITDA also differs from free cash flow, as it does not recognize the cash requirements for replacing capital assets.
EBITDA is different of operating cash flows since, for instance, uncollected receivables belong to revenues and therefore to EBITDA but not to operating cash flows. Similarly, cash paid to purchase inventory, which remains on hand if unused, would not reduce EBITDA but will reduce operating cash flow.
EBITDA, however, is most useful when evaluating a company’s true ability to earn profits, a factor that is critical for acquirers in acquisition decisions. But, EBITDA is not an accurate measure of debt-service capacity unless the creditors are actually willing to accept accounts receivable or inventory as payment of interest and principal on a loan (Mulford and Comisky 2005: 12).
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EBITDAR: A popular variation of EBITDA that is EBITDA measured before rent (lease) expense.
Adjusted Present Value
(APV)
Capital Cash Flow
(CCF): a) Net Income Version b) EBIT Version c) EBITDA Version
(R – C – D) x (1 – T) + CFA + I x T + N x T
{EBIAT} {Interest tax shield} {NOL tax shield}
(R – C - D – I) x (1 – T) + N x T + CFA + I
{Net income}
(R – C – D) - (R – C – D – I – N) x T + CFA
{EBIT} {Taxes payable}
(R – C) - (R – C – D – I – N) x T + CFA - D
{EBITDA} {Taxes payable}
Weighted Average Cost of Capital (WACC)
(R – C – D) x (1 – T) + N x T + CFA
{EBIAT} {NOL tax shield}
Where:
A = Amortization of long-term loans; C = Cost of goods sold (CGS) + Selling, general and administrative
(SGA) expenses; D = Depreciation; I = Interest expense on debt; N = Taxable income shielded by net operating loss (NOL) carry-forwards; R = Revenues, and T = Marginal corporate tax rate.
CFA = Cash flow adjustments = Depreciation + Net cash + Proceeds from asset sales or divestitures – Capital replacement expenditures - Investment in growth capital expenditures.
Two of the most troublesome problems in the crisis stage of a turnaround are deterioration of receivables and acceleration of payables. Slowing of collections can come about because of slowing sales, billing errors, extended credit granted in desperation, sloppy collection procedures, and some customers, recognizing that the company is desperate, may not pay or just deliberately delay payments.
Acceleration of payables will occur because vendors recognize the company’s plight and may refuse to ship other than on cash on delivery (COD) terms, unless the account is paid current. Often, in troubled companies there could be inadequate purchase controls (e.g., the purchase order system could have been circumvented), in which case there could be grossly understated payables, creating those unpleasant surprises of receiving unexpected invoices for unauthorized expenditures.
Current computer software can empower the turnaround managers to run infinite variations of cash projections as well as balance sheets and operating statements. By manipulating relevant variables, turnaround managers can quickly assess what would happen if collections are slowed or if payables are accelerated, or if both events occur simultaneously. The turnaround managers can alter the variables by any increment that deem useful to them in order to derive a wider picture of cash projections under wider
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range of situations and assumptions. For an illustration, see how Arthur Andersen & Company does cash flow projections using Lotus 123 software (Whitney 1999: 38-49).
Two cardinal assumptions or rules in the early turnaround stages of projecting receivables or payables are (Whitney 1999: 37):
1.
The company cash flow situation is worse than it seems.
2.
The cash flow situation will deteriorate. bad news even though they may not reduce the shock of deteriorating receivables and accelerating payables.
From hindsight, these are realistic assumptions even though pessimistic. They help you face up the
Short-term finance is concerned with the firm’s short-run operating activities. For a typical manufacturing firm, such as XYZ Inc., the short-term activities consist of a sequence of events and decisions such as those outlined in Table 4.8.
Current liabilities are short-term obligations that the company must meet with cash within a year or within the operating cycle, whichever is shorter.
The operating cycle is the time period from the arrival of stock of raw materials until the receipt of cash that accrues from the product (converted from the raw materials) when sold. That is, it begins when an order (for raw materials or finished goods) is received (in the inventory) and ends when cash is collected from the sale of the goods produced or inventory. The length of the operating cycle is equal to the sum of the lengths of the inventory and accounts receivable periods. The inventory period is the length of the time required to order, produce and sell a product. The accounts receivable period is the length of the time required to collect cash receipts.
The cash cycle or cash flow cycle begins when cash is paid for the raw materials and ends when cash is collected from receivables – that is, it is the time between cash disbursement and cash collection, from accounts payables to accounts receivables. A cash flow cycle is the pattern in which cash moves in and out of the firm. The primary consideration in managing the cash flow cycle is to ensure that inflows and outflows of cash are properly synchronized for transaction purposes. Technically, however, the cash cycle is operating cycle minus the accounts payable period. The accounts payable period is the length of the time the firm is able to negotiate to delay payment on the purchase of various resources such as raw materials and wages.
The cash flow time line consists of an operating cycle and a cash cycle. The activities listed in Table
4.8
create patterns of cash inflows and cash outflows that are both unsynchronized and uncertain. In preparing efficient cash forecast, each item listed in Figure 4.1
must be estimated by using corresponding questions listed in Table 4.8
. The need for short-term financial decision-making is a function of the gap between the cash inflows and cash outflows – that is, the length of the operating cycle and the accounts payable period. The wider or longer the gap, the more complicated the production process, the longer the production cycle, the longer the marketing cycle, and longer and heavier the financial decisions during the operating cycle. The gap is managed by borrowing or by holding a liquidity reserve. The gap can be shortened by various strategies such as just-in-time inventory, reducing inventory, and reducing accounts receivable and payable periods.
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Managers often fool themselves when it comes to cash-flow management and its importance (Kort
1999). Cash flow management implies that cash is king. However, many business executives or entrepreneurs are unlikely to accept the fact that cash is king. Entrepreneurs, especially, are impatient with the methodical task of tracking the dollars that come in and go out. If they can afford it, this job is delegated to the financial controller or officer. When cash runs short (either because of fast growth or slowing sales), most entrepreneurs become optimists and prefer to wait until next month or next quarter when things will surely improve, rather than take immediate action to confront and correct a cash-flow imbalance (Wexler 2002). This entrepreneurial delusion can tempt one to spend now and hold off paying vendors, employees, and taxes. Often, entrepreneurs spend on new projects without waiting to make money from the current business. They may not have a business plan that projects when the company will break even – that is, when it will be taking in as much cash as it is paying out. Before they realize, the cash crisis has already set in.
All companies benefit by tracing and controlling their cash flows. Every investor would be wise to check out a company’s cash flow before investing. Every creditor, supplier, and even customers, would benefit from checking the financial health of the company they are involved in from its statement of cash flows.
When insolvent, the court is satisfied if your company is failing to pay your debts when due: this is the “cash-flow test.” Alternatively, the court is satisfied if your liabilities (including contingent and prospective ones) significantly exceed your assets: this is the “balance sheet test.” Interestingly, though, not every company prepares a specific statement of its cash flows. Not all countries require such statements (e.g., Austria, India), and the most countries that do, require cash flow statements under different forms. Here we define, derive and analyze cash flow statements as per requirements in the
United States of America.
Businesses can run out of cash for several reasons (Blayney 2002: 30; Wexler 2002):
1.
Lack of profit: the available cash has been drained away by losses.
2.
Excess non-liquid assets: too much capital (cash) has been tied in fixed assets such as plant, machinery, land, slow-moving stock, or in developing new products that did not roll out.
3.
Too much growth: the business’ transactions are expanding faster that the cash resources needed to fund them; that is, the company is overtrading or over-expanding.
4.
Too many accumulating receivables.
5.
Overspending to build market share at the expense of profit.
6.
Your company is operating at less than break-even point, and for too long.
Under all these cases, the company can lose cash-flow control. The third reason seems to occur more often in the case of turnarounds. For instance, a growth-oriented firm that has grown too fast may continue to be quite profitable while at the same time get into a severe cash flow crisis (Slatter and Lovett
1999: 2). The first reason, however, is also very plausible. The profit picture of the typical turnaround situation is several years of successively low profits culminating in a loss situation and a cash-flow crisis.
Most cash flow problems occur when big customers postpone payment or pay in notes payable or by signing mortgages payable. Waiting for their payments may be nerve-wracking. Sometimes, payments from big customers may come, if ever, just a few hours before the biweekly or monthly payroll causing much anxiety, and that could seriously impair one’s abilities to function and channel energies in much needed areas of the business.
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Stay on top of your collections. High receivables and high inventory are trouble signs, even though the balance sheet may call them “assets.” Cash is an asset. You can buy groceries with it. However, you cannot buy groceries with your receivables and inventory. In fact, high receivables and inventories should be called liabilities, especially when they grow. Accumulating inventory or receivables is the first warning that the product or service is slipping while your income statement shows profits. Sales collected in the only true cash flow (Sutton 2002: 216). Receivables should be viewed as nothing more than test market expenses until they are paid. There is no sale assumed, no customer satisfaction believed, and no commission paid until the money arrives (Sutton 2002: 215).
Your accountants may say that your business is profitable. However, their assessment is mostly based on the profit-and-loss statement (which tracks non-cash items as well as dollars but not cash) or the balance sheet (which is a snapshot of assets and liabilities at one particular point in time – the end of the fiscal year). Making profits does not necessarily imply that your company is successful unless you generate cash or have access to cash when you need it. Irrespective of the health of the underlying business, if the operating cash flow cannot finance the debt and equity obligations, the company will remain fatally damaged. In such circumstances, the only solution is a financial restructuring. The objective of any financial restructuring is a) to restore the business to solvency on both cash-flow and balance sheet bases, b) to align the capital structure with the level of projected operating cash flow, and c) to ensure that sufficient financing in the form of existing cash and new money is available to finance the implementation of a turnaround plan (Slatter and Lovett 1999:90).
Cash flows are different from profits, yet both are required for long-term success of an enterprise.
Eroding profits may take a long time to cause a problem for a company, but a sudden decrease in cash flow will cause immediate discomfort (Caplan 2003: 28). On the other hand, sufficient cash flow could mask potentially serious organizational distress. For example, restaurants and retail shops may have a steady flow of cash collected from daily customers and may be able to pay the most pressing bills keeping creditors at bay. However, if at the same time the owners were to draw large sums of money, say for expansionary purposes, then a large accumulating debt could throttle their business.
In accounting practice, the inventory period, the accounts receivable (A/R) period, and the accounts payable (A/P) period are measured by days in inventory, days in receivables, and days in payables , respectively.
From the balance sheet and consolidated income statement in Tables 4.5 and 4.6 of XYZ Inc., a diversified manufacturing company, we may derive the following:
Average inventory during 2002-2003 = (1,045,00 + 700,000)/2 = $872,500 (1).
Inventory turnover ratio = (cost of goods sold)/(average inventory) = 2,000,000/872,500 = 2.29 (2).
The inventory cycle occurs 2.29 times a year or the days in inventory is 365/2.29 = 159.39 days (3).
Assuming XYZ Inc. makes no cash sales but only credit sales we may calculate the following ratios:
Average accounts receivable = (700,000 + 560,000)/2 = $530,000 (4).
Average receivables turnover = (Net credit sales)/ (Average accounts receivable)
= 4,025,000/530,000 = 7.594 (5).
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That is, the average A/R cycle occurs 7.594 times a year or the days in receivables is
= 365/7.594 = 48.06 (6).
Cash as Generated by Accounts Payable Management
Average accounts payable = (350,000 + 262,500)/2 = $306,250 (7).
Average payables turnover = (Cost of goods sold)/ (Average accounts payable)
= 2,000,000/306,250 = 6.531 (8).
That is, the average A/P cycle occurs 6.531 times a year or the days in payables is
= 365/6.531 = 55.89 days (9).
Thus, the operating cycle = days in inventory + days in receivables, which from equations (3) and (6), = 159.39 + 48.06 = 207.45 days (10).
The cash cycle = operating cycle – days in payables, which from equations (9) and (10)
= 207.45 – 55.89 = 151.56 days (11).
The balance sheet equation is:
Net working capital + fixed assets = Long-term debt + stockholders’ equity (12).
Now, Net working capital = Cash + (Currents assets other than cash – current liabilities) (13).
Rearranging (13) and substituting net working capital from (12), we have:
Cash = net working capital – (current assets other than cash - current liabilities)
= long-term debt + equity – fixed assets – (current assets other than cash - current liabilities)
= long-term debt + equity – fixed assets – net working capital (excluding cash) (14).
Δ cash = Δ long-term debt + Δ equity – Δ fixed assets – Δ net working capital (excluding cash) (15).
That is, a change (Δ) in cash is a function of change in the long-term debt of the firm, change in the equity, change in fixed assets, and change in the non-cash part of the working capital.
Equations (14) and (15) imply that some of the corporate policies for increasing cash in the firm are:
1.
Increase long-term debts (such as bonds).
2.
Increase stockholders’ equity (common and preferred stock).
3.
Decrease investment in fixed assets (like land, building, machinery and office equipment).
4.
Decrease net working capital excluding cash (which means increase accounts payable, notes payable, accrued expenses payable and taxes payable and decrease accounts receivable, inventories, marketable securities and prepaid rent).
Each of these four major policies and the implied fifteen sub-policies (within brackets) can certainly help cash flow management in turnaround situations. Much would depend, however, upon the nature, size, industry, country, competition, and legal implications of your company and its offerings. For instance, what should be the optimal size of your firm’s investments in current assets such as cash, marketable securities, accounts receivable and inventories? The solution would be a function of the level of your firm’s total operating revenues. A flexible short-term financial policy would maintain a high ratio of current assets to sales, whereas a restrictive short-term policy would do the opposite: maintain a low ratio
19

of current assets to sales. Similarly, how should your firm finance its current assets? The answer is a function of your firm’s ratio of short-term debt to long-term debt. Here again, a flexible short-term financial policy would advocate less short-term debt and more long-term debt. A restrictive policy, however, would dictate otherwise.
Any short-term financial policy has at least two sets of costs:

Carrying costs: these are costs that rise with the level of investment in current assets. For instance, a flexible short-term financial policy would keep large balances of cash and marketable securities, would maintain large inventories, and grant liberal credit terms that result in high accounts receivable. All these policies imply high carrying costs, especially opportunity costs of money and costs of maintaining the asset’s economic value.

Shortage costs: these are costs that fall with increasing investments in current assets. For instance, holding high cash balances will enable you to pay all short-term debts and liabilities without borrowing or selling marketable securities. Also, future cash flows are highest with a flexible financial policy: sales are stimulated by easy credit terms; you never run short of products and you can deliver quickly when you maintain a high finished goods inventory; and some firms could even charge higher prices for easy credit terms and quick delivery.
The opposite, however, would happen, that is, shortage costs would rise, if you decreased investments in current assets such as in maintaining low inventories of a) unfinished goods (trading and order costs would be high in this case) and b) finished goods (costs of lost sales, lost customer goodwill, disruption of production and shelving schedules would be high in this case).
Table 4.9
summarizes this argument.
Hence, in general, if carrying costs are low and shortage costs are high, the optimal policy will be a flexible one that carries high level of current assets. If carrying costs are high and shortage costs are low, then a restrictive policy of maintaining low level of current assets may be optimal.
Given the primary importance of cash, cash flows, and cash flow management to any business, the statement of cash flows has become one of the central financial statements. It provides a thorough explanation of the changes that occurred in the firm’s cash balances during the entire accounting period.
The statement of cash flows enables both investors and managers to keep their fingers on the pulse of any company’s lifeblood: cash. Companies that lose too much cash become critically ill or bankrupt.
Bankruptcy is loosely used to refer to companies that are unable to meet their financial obligations.
In the United States, prior to 1971, companies were required to prepare only the balance sheet and income statement. That year, a statement showing the changes in financial position between balance sheets was added. However, financial problems, mainly inflation in the 1970s and 1980s, caused many economists and accountants to call for a greater emphasis on cash management. In response, in 1987, the
Financial Accounting Standards Board (FASB) required the preparation and presentation of the statement of cash flows in its present form.
While the balance sheet shows the financial status of a company at a single point in time, the statement of cash flows and income statements show the performance of a company over a period of time.
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Both explain why the balance sheet items have changed. The statement of cash flows explains where cash came from during a period and where it went.
The statement of cash flows reports all the cash activities (both receipts and payments) of a company during a given period. It also explains the causes for the change in cash by providing information about operating, financing, and investing activities.

Operating activities are generally activities or transactions that involve producing and selling goods and services, and they affect the income statement (e.g., sales are linked to collections from customers, and wage expenses are related to cash payments to employees).

Investing activities reflect increases and decreases in long-term assets. They involve the purchase and sales of long-term assets such as land, building, computers, software, equipment, and investments in other companies. Loans to others, and collection of loans from others, are investing activities.

Financing activities involve obtaining resources as a borrower or issuer of securities and repaying creditors and owners. These activities include issuing stock, borrowing money, buying and selling treasury stock, and paying dividends to stockholders.
Note, however, that financing and investing activities are really opposite sides of the same coin. For instance, when stock is issued for cash to an investor, the issuer treats it as a financing activity while the investor treats it as an investing activity. Financing cash flows relate to long-term liabilities and owners’ equity. Table 4.10
lists operating, investing and financing activities, their nature as inflows or outflows, and their impact on cash. The relationship of these activities to cash is fairly straightforward and obvious.
What is not always obvious is the classification of some activities as operating, investing or financing.
For instance, interest payments and dividend payments are both outflows whose impact on cash is negative, and both seem to be disbursements related to financing activities. After much debate, however, the FASB decided to classify interest payments as cash flows associated with operations and dividends payments as financing cash flows.
Table 4.10
reflects this decision. This classification maintains the long-standing distinction that dividend transactions with the owners cannot be treated as expenses, while interest payments to creditors are expenses incurred for operations (Horngren, Sundem, and Elliott 2002: 411).
According to FASB, the purpose of cash flow statements is (Harrison and Horngren 2004: 546-7):
1.
It shows the relationship of net income to changes in cash balances. For instance, cash balances can decline despite positive net income, and vice versa. Usually cash and net income move together.
High levels of income tend to lead to increases in cash, and vice versa. A company’s cash flow, however, can suffer even when net income is high.
2.
The cash flow statement reports cash flows as an aid to predict future cash flows, to evaluate the way the management generates and uses cash, and to determine a company’s ability to pay interest and dividends and to pay debts when they are due. Past cash receipts and payments are good predictors of future cash flows.
3.
It identifies changes in the mix of productive assets.
4.
It can evaluate management decisions. The statement of cash flows reports cash flows from operating activities, investing activities and financing activities. This gives investors and creditors cash flow information for evaluating management decisions.
5.
Determine the company’s ability to pay dividends to stockholders and interest and principal to creditors.
6.
The statement of cash flows can help investors and creditors predict whether the business can make these payments.
21

Following the listing of activities in Table 4.10
, we next track and compute cash flows from the operating, investing, and the financing activities of a firm. Computing cash flows from investing and financing activities is fairly straightforward and easy, whereas computing cash flows from operating activities is somewhat complicated. We first undertake computing cash flows from operating activities.
The operating section of the statement of cash flows reports the cash effects of operating activities.
Operating activities create revenues, expenses, gains, and losses. They are the most important of the three categories (operating, investment and financing activities) because they are at the heart of every organization. They affect net income on the income statement, a product of accrual-basis accounting.
Operating activities also affect current assets and current liabilities on the balance sheet. For instance, a sale on account increases sales revenue on the income statement and accounts receivable (current asset) on the balance sheet.
Two approaches are used in computing cash flows from operating activities (or operations): direct method and indirect method. In the direct method , we report all cash receipts and cash payments from operating activities; that is, cash flows are computed as collections less operating disbursements. In the indirect method , which reconciles from net income to net cash, we adjust the accrual net income to reflect only cash receipts and cash outlays.
Under the direct method , we identify the cash part of each item in the income statement. Because depreciation does not use cash, it is not part of the calculation. We use equation (15) to compute the change in cash under each operating activity.
Δ cash = Δ long-term debt + Δ equity – Δ fixed assets – Δ net working capital (excluding cash) (15).
That is, any change in cash in the left-hand side (LHS) of (15) must be accompanied by a change in one or more items of the right-hand side (RHS) of equation (15) to keep the equation in balance. The
LHS of equation (15) tells us what happened to cash; the RHS of (15) tells why it happened. The statement of cash flows focuses on the changes in the non-cash accounts in the RHS of (15) as a way of explaining how and why the level of cash went up or down during a given period.
We can further simplify equation (15) as follows:
Δ cash = Δ long-term debt + Δ Stockholders’ equity – Δ fixed assets
- Δ (current assets excluding cash – current liabilities)
= Δ (long term debt + current liabilities) + Δ Stockholders’ equity
- Δ (fixed assets + current assets excluding cash) (16).
= Δ (Liabilities) + Δ (Stockholders’ equity) – Δ (non cash assets)
= ΔL + ΔSE – Δ NCA …. (17).
We will use equation (16) to compute cash flows from all operating activities. To illustrate computing cash flows, consider the balance sheet ( Table 4.5
) and income statement ( Table 4.6
) of XYZ
Manufacturing Corporation. As of June 30, 2003, the following operating activities can be derived from
Tables 4.5 and 4.6
(all figures are in $millions) and these are listed in Table 4.11
. Those that impact cash will be marked by an asterisk (*). Some entries in Table 4.11
need explanation.
22

Collection of accounts receivable from customers: (figures in $000s)
Sales on credit: 4,025.00
Accounts receivable at the beginning of fiscal year 2003: 560.00
Potential collection: 4,585.00
Less: ending accounts receivable 700.00
Cash collection from customers during 2003: * 3,885.00
Alternately:
Sales 4,025.00
Less: Increase in accounts receivable: 140.00
Cash collection from customers: 3,885.00
Purchase of inventory on account and Payment to suppliers : (figures in $000s)
Ending of inventory: 1,045.00
Plus cost of goods sold: 2,000.00
Inventory to account for: 3,045.00
Less: beginning inventory 700.00
Purchase of inventory: 2,345.00
Less: Beginning trade accounts payable: 262.50
Total amount to be paid: 2,607.50
Less: Ending trade accounts payable: 350.00
Amounts paid to suppliers for inventories in cash:* 2,257.50
The same amount paid for inventories during 2003 can be computed as follows:
Cost of good d sold: 2,000.00
Increase (decrease) in inventory: 345.00
Decrease (increase) in trade accounts payable: (87.50)
Payments to suppliers:* 2,257.50
Payment of Wages to employees
(figures in $000s)
Beginning wages and salaries 78.75
Wages 800.00
Total wages to be paid: 878.75
Ending wages and salaries payable: 87.50
Cash payments to employees:* 791.25
Alternately:
Wages 800.00
Less: Increase in wages payable: : 8.75
Cash payments to employees: 791.25
Payment of taxes
(figures in $000s)
Beginning income taxes payable: 78.75
Provision for income tax 213.50
Total income tax to be paid: 292.25
23

Less: Ending income taxes payable: 87.50
Cash payments to taxes:* 204.75
Alternately:
Taxes 213.50
Less: Increase in taxes payable: 8.75
Cash payments to employees:* 204.75
Payment of Interest: (figures in $000s)
Beginning interest payable: 10.00
Interest on bonds and other liabilities 105.00
Total interest to be paid: 115.00
Ending interest payable: 10.00
Cash payments to interest:* 105.00
Alternately:
Interest on bonds and other liabilities 105.00
Less: Increase in interest payable: 0.00
Cash payments to interest:* 105.00
The other elements in Table 4.11
such as rent paid ($50,000), miscellaneous expenses ($20,000), prepaid rent ($5,000), selling and administrative expenses ($490,000), and dividends and interest ($
17,500) that are included under operating activities are straightforward since there are no beginning and ending entries for these cash flow items. Depreciation is entered, but there are no cash flows associated with it. Depreciation is an allocation of historical cost to expense and does not entail a current cash outflow. Net cash provided by all operating activities is - $21,000.
The second major section of the statement of cash flows is from investing activities such as the sale of plant, property, equipment, and other long-term assets. Long-lived assets are investments. Thus, we need to report four cash flow items under investing activities: a) acquisition of fixed assets, b) disposal of fixed assets, c) prepayment and deferred charges, and d) change in intangibles. For XYZ, however, items (b) and (d) are zero. Items (a) and (c) are computed as follows:
Payment of machinery and plant as fixed assets : (figures in $000s)
Beginning machinery and plant: 280.00
Ending machinery and plant: 525.00
Cash payments to machinery and plant:* 245.00
Prepayment and deferred charges : (figures in $000s)
Beginning prepayment and deferred charges 105.00
Ending prepayment and deferred charges 140.00
Cash payments to prepayment and deferred charges 35.00
Thus, the net cash provided by investing activities is (-245 + - 35 =) - $280.00 (In thousands).
24

The third major section of the statement of cash flows is from financing activities. These flows describe the source of capital such as stocks, bonds, and notes payable that were used for financing the purchase of fixed assets under “investing activities”. For XYZ Inc., there was no fresh issuance of stock during the fiscal year 2003, nor was there the incurrence of long-term debt, but $31,500 was paid out in dividends. Net cash flows from notes payable and marketable securities are computed as follows:
Increase in notes payable: (figures in $000s)
Beginning notes payable: 165.50
Ending notes payable: 515.00
Cash inflows from increase in notes payable 350.00
Increase in marketable securities: (figures in $000s)
Beginning marketable securities 157.50
Ending marketable securities 175.00
Cash payments to net marketable securities 17.50
Thus, net cash provided by financing activities was (-31.50 + 350 – 17.50 =) $301.00 (in thousands)
In conclusion, net cash flows from all activities: -$21,000 from operating activities, -$280,000 from investing activities and +$301,000 from financing activities. The net cash is (-21,000 – 280,000 +
301,000 =) 0.00 dollars. This figure of net cash of 0.00 dollars matches that of Table 4.3
. During the fiscal year 2003, total cash outflows were (-4510 + -175 =) -$4,685 millions and total cash inflows were
(+437.50 + 4247.50 =) +$4,685 millions, resulting in zero net cash balance.
Table 4.12
is a statement of cash flows using the indirect method referred to earlier. The indirect method is convenient and reconciles net income to the net cash provided by operating activities. It also shows the link between the income statement and the statement of cash flows (if provided). In the indirect method, the statement of cash flows begins with net income. Then, additions or subtractions are made for changes in related asset or liability accounts. Thus, Table 4.11
computes cash flows starting from net income, while Table 4.12
computes cash flows from all the operations during the fiscal year
2003, starting from sales revenues.
The main difference is that Table 4.11
is a statement of the sources of cash versus uses of cash and combines all operating, investing and financing activities together. If we separate the figures by operating, investing and financing activities these numbers are identical to those of Table 4.11
as is evidenced in Table 4.12.
Note that depreciation (even though not a cash flow item) is added back to net income just because it was deducted in the computation of net income in the Income Statement (see Table
4.6
). Its addition now cancels its deduction in calculating net income.
While all the three sets of activities, namely, operating, investing, and financing operations, are important for a business, the nature of their net cash flows (positive versus negative) have different
25

implications for the health of the firm in a given industry. With positive or negative net cash flow states
(+ or -) under each of the 3 sets of activities, there are eight (2 3 ) combinations that we could explore.
Table 4.13 captures some of the business growth and health implications under each of the eight cases.
In general, investors (e.g., shareholders, venture capitalists, investor institutions) prefer firms that are growing as represented by the negative net cash flow in investing activities (cases 3, 4, 7 and 8), but which can still qualify for long term debt and attract shareholder capital by issuance of new stock, and pay out less dividends for higher retained earnings, thus maintaining positive net cash flows from financial activities (cases 3 and 7). Between cases 3 and 7, investors prefer case 3 as one that is continuously generating positive net cash flows from its operating activities. Typical current case 3 companies in the United States are homebuilder companies (e.g., Fanny May, Lennar, D. R. Horton,
Centex, Plute Homes), and computers and software IT companies (e.g., Dell, Microsoft, IBM, Hewlett-
Packard) that are high growth industries, high growth in profits and represent relatively young industries.
Case 7 companies are young, high-risk, speculative, and those struggling hard to generate positive net cash flows from their operations while investing heavily in new technologies and acquisitions, and attracting heavy investor capital. Most dot.com companies that survived the year 2000 crash belong to this group, such as eBay, Amazon.com, Google.com and Yahoo!
The next best scenario is case 1 with positive net cash flows in operating, investing and financial activities. These are old, steadily growing, and high long-term profit companies in the United States, such as petroleum refining companies (e.g., Exxon Mobil, Chevrontexaco, Conocophilips) and pharmaceutical companies (e.g., Johnson & Johnson, Pfizer, Merck, Bristol-Myers Squibb). Case 4 companies (+ - -) rank next in performance and for reasons suggested in Table 4.13
.
Case 5 companies are interesting. They represent the old but still high-risk industries with uncertain profitability, but are still promising, and hence, generate negative net cash flows from operating activities but positive net cash flows from investing and financing activities. Currently, hospitals, hotels, casinos, commercial banks and airlines belong to this category.
Cases 2 is a relative opposite of case 5: represents old industries with steady but low profit operations, positive cash flows from selling old fixed assets such as land, building and equipment, but are failing to attract venture or shareholder capital. Typical U. S. industries struggling in this category are chemicals, steel, railroad, tobacco, shipping, forest and paper products and energy companies.
Cases 6 and 8 are distressed companies that need turnaround management. Here, the problem may not be linked with the industry (young or old, dynamic or static) or with the company’s growth stage in the cycle (young, mature or old). There is a management problem of apathy or inefficiency, or downright fraud and deception.
Venture capitalists, investors and lenders use accounting data to evaluate companies. Venture capitalists look for good value-creating innovations that can be brought to large target markets. Investors typically look for corporations whose stock price will increase and which pay high dividends. Lenders
(especially, banks) want to lend to borrowers who will repay their loans on time. Accounting provides a framework for organizing the necessary financial information. The accounting framework can be on accrual basis or cash basis.
In accrual accounting , an accountant recognizes the impact of a business transaction as it occurs (e.g., a sale is made, an expense is incurred) and records the transaction even if it receives or pays no cash. The
Generally accepted accounting practices (GAAP) require that businesses use accrual accounting. In cash-
26

basis accounting, revenues are recognized as cash is received and expenses as cash are paid. That is, the accountant records a transaction only when it receives or pays cash. Actual cash receipts are treated as revenues and actual cash payments are reckoned as expenses . Accrual accounting, on the other hand, records all types of cash-transactions , including all types of receivables (e.g., actual and future collections from customers, cash from interest earned, borrowing money, issuing stock), and all types of payables
(e.g., paid, accrued or deferred salaries, rents, taxes and other expenses, paying off loans).
Accrual accounting also records all types of non-cash-transactions , such as inventory purchase on account, sales on account, accrual of expenses incurred but not yet paid, depreciation expense, and usage of prepaid rent, lease, insurance, and supplies. All transactions are recorded when they are completed and either revenues are earned or liabilities or payments are incurred, even though either may not have resulted in actual cash receipts or disbursements. The amount recorded is the cash value of the transaction (e.g., sales as revenue or purchase as expense). Accrual accounting, thus, completes the process leading up to the financial statements.
Accrual accounting, however, poses ethical problems that cash-based accounting can avoid. For instance, if in August 15, 2006 your turnaround advertising company, ABC, received a prepaid amount of
$3 million from your client PQR for advertising services for the next three months starting from August
31, 2006. Suppose your fiscal year ends September 30, 2006, how should you report this transaction in your financial statements? It should be:
Financial Statements ABC Company: September 30 2005 – September 30 2006:
Income statement (September 30, 2006):
Advertising service revenue earned (from PQR for September 2006) $1 million
Balance Sheet statement (September 30, 2006):
Liabilities: (unearned advertising service revenue for October/November 2006) $2 million
Statement of cash flows (September 30, 2006):
Cash receipts (August 15, 2006) $3 million
Now, if a) you want to look good on net income for the fiscal year 2006 (and are expecting a promotion based on net income), you may be tempted to report all $3 million as earned revenue for fiscal year ending September 30, 2006. Alternatively, if b) you are expecting a lean year and want to look good for the next fiscal year, you could report the entire transaction as accruing for the next fiscal year. The unethical action would be to pre-pone $2 million advertising unearned revenues of fiscal year 2007 to
2006 in the first instance (case a), or to postpone $1 million earned earnings of fiscal year 2006 into 2007 in the second context (case b). Worse, if knowing ABC is in trouble, PQR voids the contract and demands back $2 million of prepaid expenses, then you are already $2 million short when starting to turnaround ABC. Under cash-basis accounting, ABC would record the full amount $ 3million as earned revenues in October 30, 2006 because the prepaid amount will become fully earned revenues by that day.
However, the cash basis accounting is unacceptable for GAAP because it distorts reported figures for assets, expenses, and the net income.
Another ethical challenge in accrual accounting can arise if you choose to overlook an expense at the end of the period. If by the end of September 2006, you found the year has been really bad, you could be tempted to “manufacture” net income by postponing some expenses (e.g., you owed $ 2 million in interest expense to your bank by October 30, 2006) to fiscal year 2007 (under case a) or vice versa, under case b).
This easy manipulation process can explain most of the accounting irregularities listed in Appendix 2.1
.
27

Whatever the accounting system used, any organization needs an effective system of internal controls for cash flow management. In general, an objective system of internal controls would have the following characteristics (Harrison and Horngren 2004: 181-185): a) b)
Competent, reliable and ethical personnel: Train, retain and develop your employees by supervising them, rotating their jobs, paying good salaries, and holding them responsible for all their operations.
Assignment of responsibilities: Each employee should be assigned specific duties and responsibilities and should report to either the treasurer or the controller. The treasurer usually c) d) e) f) g) manages cash, while the controller is in charge of accounting. The two departments should be kept separate. For instance, the controller may be responsible for approving invoices (bills) for payment, while the treasurer may actually sign the checks. This avoids anyone signing checks for oneself. Working under the controller, one accountant is responsible for property taxes and another, for income taxes.
Proper Authorization: An organization generally has rules that outline approved procedures. Any deviations from standard policy require proper authorization from the right person.
Supervision of employees: Even the most trusted employees could be opportunistic and be tempted to steal or defraud the company if they are not properly supervised. All employees, no matter what their position, including the CFO and the CEO, need supervision. Hence, the prospect of making the CEO also the Chairman of the board of directors violates this rule.
Separation of duties: Separation of duties limits fraudulent practices. For instance, accounting should be completely separated from a company’s operating departments (e.g., manufacturing, sales). Accountants should not be allowed to handle cash, and cashiers should not have access to accounting records. If the same employee has both accounting and cash-handling duties, that person can steal cash and conceal the theft by making a bogus entry on the books. While the company treasurer handles cash, the company controller should handle accounts. Similarly, computer programmers should not operate a company’s computers, as they can program a computer to write checks to themselves.
Internal and external audits: Typically, an auditing firm examines the company’s financial statements, accounting systems, and internal controls. Auditors must be independent of the operations they are auditing. Auditors can be internal or external. Internal auditors audit throughout the year checking various segments of the organization to ensure that employees follow company policies. External auditors are periodically hired from outside; they audit the entity as a whole and are concerned mainly with the financial statements.
Electronic and computer controls: Currently, there are several electronic devices to safeguard a company’s assets, especially cash and checks. Electronic sensors attached to merchandise can reduce theft by 50 percent. Computer software can control accounting systems, check-writing systems, payroll systems, purchasing systems, retailing check out systems, and the like.
Any business entails risk. Even every specific business activity implies risk. Growth in production, number of brands, number of retail outlets, sales revenues, customer loyalty, market share and profits seldom come from risk-free or risk-eliminating strategies. Some risk is inevitable.
In general, economic risk comes under four types (Arnold 2007: 511-514): business risk, insurable risk, currency risk, and interest rate risk.

Business Risk: This is the every day risk of operating a business in a competitive environment. It is the variability of the firm’s operating income (i.e., income before interest and taxes) brought about by internal factors (e.g., cost overruns, evolving production technologies, poor product quality, wage inflation, labor boycotts) and external factors (e.g., industry stagnation, recession, unemployment, reduced consumer buying power, changing customer lifestyles, government regulation, competitive
28

advantage, new competitive entrants, and globalization). Consequences of both factors could imply a decline in sales revenues and/or market share and, therefore, in profits. Similarly, costs may also rise owing to wage inflation, inflated wage benefits, strong labor unions, overstocked inventories, increasing receivables, accumulating payables, bad debts, theft, merchant or consumer fraud, tight commodity markets, government imposed quotas, tariffs and custom protocols, credit squeeze, rising interest rates, EPA regulation, or political turmoil. Some of these risks are inevitable and unmanageable, while some can be reduced by insurance, hedging, derivatives, flexible designing, reengineering, futures trading, trading carbon emissions allowances, securitization, vertical or horizontal integration, divestitures, mergers and acquisitions, or seeking chapter 7 or 11 bankruptcy protection. In general, business risk is determined by general business and economic conditions and is not related to the firm’s capital or financial structure. On the contrary, financial risk is the additional variability in revenues and returns that arises from the firm’s financial structure.

Insurable risk: Most business operations involve risk such as risk to employee life, risk to productivity, risk of defective products, risks of cost overruns, risk of market uncertainty, risk of consumer rejection, or risk of government over-regulation. Corporate executives can sell or transfer many such business risks (specifically, factory fires, worker accidents, machinery damage, ecological degradation, and hurricane damage) to insurance companies through the payment of insurance premiums. Insurance companies (e.g., Prudential, MetLife, AIG, and Hartford) handle risk better than commercial banks or ordinary commercial firms. That is, they: a) can better estimate, through long experience, the probabilities of occurrences of bad events and, accordingly, price risk premiums, b) know methods of reducing risk better and can pass on their knowledge to commercial clients to obtain lower premiums, and c) can pool risk or diversify risk better (e.g., AIG sold over 250 different insurance products such as fire, marine, defense, workplace, health, home, collision, accident, car, and mortgage insurance packages), and hence, can lower their premiums to be competitive.
Insurance premium prices will also reflect two additional phenomena called “adverse selection and
“moral hazard” (see below).

Currency Risk: If the company is multinational in its supplier and customer base, then payments will have to be made or received in currencies of the transaction-originating country or converted to any hard (G Seven or G Eight) currencies. The currency risk would then reflect currency appreciation or depreciation via a hard currency, the commission for each transaction, and other charges.
Currency risk can be reduced by hedging currency fluctuations. For instance, if you are buying hundred million Yen worth of steel from Japan three months from now, then you could agree (hedge) the price of Japanese steel either at today’s prices or at forward prices of steel three months from now.

Interest Rate Risk: Volatile interest rates are difficult to predict with accuracy. If your debt is large with a floating interest rate, then rising interest rates will harm you. Alternately, if your debt is large and with a fixed interest rate, then declining interest rates will make you pay higher debt costs than necessary. Commercial banks and insurance agencies provide various financial instruments that can help you to cap the interest rates.
Economic or market risk is always with us, mostly in the form of credit or liquidity crisis. Recent financial disasters include:

The U. S. Savings & Loan crisis (1986-1995);

Black Monday in 1987

The Russian debt default and the related dive of Long-Term Capital Management in 1998;

The Japanese banking crisis (1990-1999);

The Asian financial crisis (1998-1999);

The dot.com bust of 2000, and

The Enron-led merchant power collapse of 2001

The financial market crisis of September-October 2008
29

As the recent economy began to stall, the underlying problem of consumer and corporate indebtedness in the USA totaled about 380% of GDP, nearly two and a half times the level at the beginning of the Great Depression. In 2007, major financial institutions have written off nearly $400 billion in losses, and central banks around the world have initiated emergency measures to restore liquidity. In the latter half of 2008 alone, around 18 major banks of USA lost over a trillion dollars in capitalization (see Table 2.1
under Wicked Problems).
A good business strategy seeks to trade-off the costs of absorbing inevitable risks versus enjoying the benefits of such risks. There are several reasons why firms sacrifice potential profits in order to spread or sell risk (Arnold 2007: 510). a) It helps financial planning : Predicting and controlling risks of fluctuating material costs, interest rates, and currency exchange rates can enable you to predict and manage your cash flows within certain boundaries, and, accordingly, help you to plan and invest with confidence. b) It reduces the fear of financial distress : Buying proper insurance can shield your firm from potential and unforeseeable damages (e.g., from earthquakes, hurricanes, damage from toxic products such as asbestos, coal and carbon emissions, and supertankers from ocean oil spillage), relieve you and shareholders from undue stress, and your banks will be empowered to extend you credit.
Businesses and markets are fraught with risks along the backward, middle and forward value line.

Backward Value Line: misdirected market scanning, untargeted product research, under-budgeted
R&D; hence, risk of poorly identified market niches, bad business ideas, wrong business concepts, flawed product prototypes, defective product designs, overpriced raw materials, defective production processes, risks of labor apathy and malaise, low product quality, and cost overruns;

Middle Value Line: poor product bundling, unattractive product packaging, confusing product labeling, flawed product costing, overstock product inventory, ineffective product logistics and delivery;

Forward Value Line: unimaginative product pricing, unattractive product-price bundling, lackluster product advertising, ineffective product rebates, too easy product credit, risky product financing, poor promotions, unsatisfactory products and services, un-honored product warranties and guarantees, and risks of market rejection.
Coupled with almost all value line risks are the general risks of inflation, wage inflation, stagflation, unemployment and reduced consumer-buying power, risk of currency fluctuations, risks of volatile interest rates and mortgage rates, risk of business loan rejection, risks of junk bond ratings, risks of shareholder unrest, and the like. Hence, strategic decision-making has to with what risks a business should undertake, and what risks it should carefully avoid, and under what intended and unintended consequences the executives must foresee.
In general, business risk (i.e., project risk, new product risk) is associated with three types of error: a) Type I Error: also called alpha error. This error arises when a business executive, in an effort to eliminate or minimize risk, rejects something (e.g., an idea, a business concept or model, an innovation, technology, or market opportunity) as false when it is true , as non-existent when it really exists, as wrong when it is right. This is the error of ignored evidence. It spells the cost of a lost
30

technology, product or service or market opportunity. Type I error is producer risk. Many companies, for instance, cancel promising projects and products too early for lack of adequate data, that is, for lack of evidence that it could succeed. Such alpha errors result from a failure to conduct the right experiments to reveal a project’s or product’s potential, often because of organizational or personal biases against the project or because of shortage of resources. For examples, the biggest pharmaceutical blockbuster, Prozac, narrowly escaped cancellation due to Type I error; Xerox abandoned projects that went on to drive the success of Documentum and 3Com. b) Type II Error: also called beta error. This error arises when a business executive, in an effort to manage risk, accepts something (e.g., an idea, a business concept or model, an innovation, technology, or market opportunity) as true when it is false , as existent when it really does not exist, or as right when it is wrong. This is the error of selective evidence . The effect of this is a bad product, a defective technology, a flawed business model, and eventually, this error impacts the consumers and the markets. Hence, Type II error spells consumer risk. In this case, managers ignore evidence challenging their assumption that a project or product will succeed. There are many reasons for
Type II error: power of product champions to stir collective faith in a project’s promise; a dogmatic, success-seeking mentality; the human tendency to seek only evidence that supports our beliefs and assumptions (Isabelle 2003). Despite multiple red flags, new product managers rush products to markets, only to fall dramatically after their launch. Thus, ignored evidence abounds in industries ranging from chemicals and pharmaceuticals to building materials to entertainment products, where new products of questionable viability are propelled to the market (e.g., RCA’s videodisk; Ford’s
Edsel and Pinto; GM’s EV1). c) Type III Error, also called gamma error. Tukey (1975) described this error as “solving the wrong problem,” that is, the error of wrong problem formulation, hence, deriving a wrong solution. While a problem well formulated is half solved, a problem badly formulated generates either new problems or wrong solutions. This error happens when you reject a real problem, or a right problem formulation and accept a wrong formulation of either the problem or its resolution. Hence, Type III error is a combination of both Type I and Type II errors. Such errors are disastrous and spell both
producer and consumer risk. This error represents a willingness to kill a product early and a willingness to persist until its potential is realized. Some people become so afraid of failing that they are unable to do a critical experiment. Some people, on the other hand, are so enamored of success that they ignore evidence of critical experiments to the contrary. Pharmaceutical and entertainment companies are famous for products rushed to the market; governments, universities, churches, and in general highly bureaucratic organizations, are known for delayed projects and products.
You could increase your chances of success in new product development by dividing the NPD process in early and later stages. In the former, your goal is to eliminate quickly poor candidates and absorb risk; in the latter, your goal is to increase the probability of national launch and market success.
This segmented approach is a good bet for your company if (Bonabeau, Bodick and Armstrong 2008):

If 60% to 80% of new product candidates would be eliminated at the early stages of NPD;

If 70% to 90% of the rest would go on to successful market launches and market success;

If per project costs are less (say one-fifth to one-fiftieth) at early stages of NPD.
This segmented approach to NPD is particularly suitable to drug development in the pharmaceutical industry because it reduces risk in an environment where project costs and failure rates are very extremely high. In fact, any company that needs to absorb a lot of risk in early-stage development (e.g., in the chemical, biotechnology, medical devices, high technology, and semiconductor industries) should use this segmented approach. This approach makes less sense for products that imply low development costs, low failure rates, and for products that are well served by current engineering or rapid prototyping approaches that promote fast scale-up at relatively low risk (Bonabeau, Bodick and Armstrong 2008: 98).
31

Bonabeau, Bodick and Armstrong (2008: 98-102).characterize the early and late stage NPD process as follows:
Seek project/product truth Seek brand market success Goal
Strength
Approach
Establish new project/product’s promise or lack of it
Typically, the cost of early stage development are low; hence, conduct many and short experiments
Reduce risk and uncertainty
Reduce Type I or alpha error
Maintain loyalty to the experiment and scientific rigor to experimentation
Focus on scientific method
Operate with low fixed costs, low capital requirement
Work in small experiment-based teams
Emphasize product testing
Take a product to the market
Typically, the cost of late stage development are high; hence, conduct few but sure product campaigns and launches
Maximize value and profitability
Reduce Type II or beta error
Maintain loyalty to the project or product
Focus on commercialization
Operate with high fixed costs, high capital requirement
Work in large product-based teams
Emphasize brand refining
Eliminate useless candidates
Do not ignore evidence of low promise or high product risk;
Promote promising candidates
Emphasize selective evidence of promise and success
Expose the truth about risky prospects Exploit the truth for maximizing quickly and cost effectively likelihood of product launch
Willingness to kill a useless product early Willingness to persist until the product’s potential is realized
Decrease the probability of launch Increase the probability of launch
Repeated and frequent experimental tests of product feasibility, viability, safety, toxicity, side-effects, legality, patent infringement and ecology
Sustained clinical tests of product strengths, uniqueness, differentiation, customization, potency and economy in use
Many important financial innovations in risk management have originated in the banking and securities industries. This is because financial institutions are basically risk intermediation or risk securitization businesses. Risk management became the core competence of such institutions. The more sophisticated the financial institutions were, the better they could describe, price, and manage risk.
Moreover, these institutions are rich in financial data, and hence, a natural locus for quantifying risk using sophisticated statistical methods. Moreover, their investors and shareholders kept exerting increasing pressure on these financial institutions to improve risk management. Thus, for all the above reasons, financial innovations have taken place primarily in risk management of securities, bond options, and derivatives.
For the first 70 years of the 20 th century, corporate risk management was largely about buying insurance. Bank regulators lacked tools for measuring risk in the funds lending and depositing system, and hence, constructive intervention was difficult. Moreover, banks themselves could not control the interest-rate risk in their loan portfolios nor quantify or manage credit risk – partly because, few
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alternatives to insurance were available. Innovation in risk management was further slowed down by the then prevalent “indifference theory” advocated by Franco Modigliani and Merton Miller that argued that a company’s value was (in most cases) not affected by its capital structure. That is, in a perfect market
(e.g., no taxes, no bankruptcy costs, no asymmetric information), the value of a company is independent of its capital structure (e.g., debt-equity leverage, hedging). Obviously, this theory originally proposed in
1958, did not hold too long in the real world of taxes, bankruptcy costs, and asymmetric market information. There was a need for efficient capital structure and risk-mitigation through hedging.
Hence, in the 1960s, William Sharpe and his associates introduced the Capital Asset Pricing Model
(CAPM). The authors argued that the markets compensate investors for accepting systematic or market risk but do not discount for idiosyncratic risk, which is specific to an individual asset and can be eliminated through diversification. That is, the authors argued that investors should manage risk primarily through portfolio diversification and hedging.
All this changed in 1973, by the landmark “Options-Pricing Model” introduced by Fischer Black and
Myron Scholes, and expanded later by Robert C. Merton. They argued that the volatility of a security is a key factor in options pricing. Hence, their new model enabled more effective pricing and mitigation of risk. The model calculates the value of an option to buy a security as long as the user could supply five pieces of data: a) the risk-free rate of return (mostly defined as the return on a three-month U. S. Treasury bill); b) the price at which the security would be purchased (usually given); c) the current price at which the security was traded (this could be observed in the market); d) the remaining time during which the option could be exercised (given), and e) the volatility of the security (which could be estimated from historical data). The equations in the model assume that the underlying security price volatility mimics a
Brownian motion (random way in which air molecules move in space).
The Black-Scholes model addresses a core idea called optimality that is embedded in all financial instruments, capital structures, and business portfolios – these are options that can expire, can be exercised, or sold. Most options are obvious and bounded (e.g., an option to buy General Electric stock at a given price for a given period). Other options are more subtle. The Black-Scholes Model assumes that the holders of equity in a company with debt in its capital structure have an option to buy back the firm from the debt holders at a strike price equal to the debt of the company. Some options depend upon the company’s real operations; e.g., the option to cancel or defer a project or venture. The theory of real options places a real value on managerial flexibility – something overlooked in straightforward NPV calculations that assume an all or nothing attitude toward projects.
Several concurrent innovations enabled the spread and popularity of the Black-Scholes model.
Around 1973, Texas Instruments marketed an early version of financial calculators with the possibility of computing Black-Scholes values. Options traders accepted the TI calculator readily, and this also fueled the growth in derivative markets and the broad development of standard pricing models.
Other innovations quickly followed:

In 1975, the first personal computers were launched.

In 1979, Dan Bricklin and Bob Frankson released VisiCalc, the first spreadsheet designed to work on a PC, giving managers a simple tool to work on simulations of what-if financial market scenarios.

In the 1980s, Sun Microsystems, Digital Equipment and the Bloomberg Terminal developed ingenious work machines called workstations that revolutionized price calculations in derivatives and fixed-income markets respectively.

In the 1990s, other firms (e.g., Crystal Ball) developed software that allowed traders to run Monte
Carlo simulations within a few minutes on laptops, rather than overnight on mainframe computers.
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
In the late 1990s and 2000s, financial markets got so sophisticated that they developed “synthetic
CDOs” – derivatives of derivatives of derivatives. This was the fastest growing sector of the multitrillion dollar market for collateralized debt obligations (CDOs) until credit crunch began in late
2007.
Thanks to these easy financial computing innovations, by the beginning of the 1990s, investors could buy contracts that covered a wide variety of risks using derivatives of various kinds – options, futures, and swaps, in all combinations. Derivative markets began with currencies, equities, and interest rates, and quickly expanded to include commodities like energy and metals.
In a second wave of innovation, financial instruments emerged that allowed the hedging or transfer of credit risk – at that time a major remaining category of financial risk and a subject of concern among bank regulators. By the end of 1990s, derivative markets were exploding; the notional value of the securities involved rose from $72 trillion in 1998 to $370 trillion in 2006, and $600 trillion by the end of 2007
(Buehler, Andrew and Hulme 2008: 94-98).
The Black-Scholes (1973) Model of optionality relates to securities. However, optionality goes well beyond securities and financial services. It implies that a company’s equity is a “basket option” in which its various risks are pooled. Each shareholder is exposed to a tiny fraction of the risk to which the company is subject. Thus, a simple but useful way of thinking about the company’s balance sheet is to see its equity as a cushion against the risk of performing badly. The risk that its market value will go down is borne by the shareholders. No such cushion is offered by debt, as the accrued interest must be paid regardless how the company performs. The optimal debt level of a firm is determined by a company’s key market, financial, and operating risks; it is directly affected by actions that mitigate those risks. CFOs, therefore, can add value by separately and more cheaply hedging those risks ordinarily managed by equity cushion. If risks can be priced and traded, it makes better sense for companies to sell off those risks where they have no comparative advantage. Modern financial tools enable companies to free up that capital and get it working to create value. Smart financial engineering can free-up equity capital for strategic (value-adding) investments, allowing a firm to finance more value-adding growth for the same amount of equity (Merton 2005).
A good strategy plans an optimal mix of debt and equity, short-term borrowing and long-term borrowing, fixed rate financing versus variable rate financing, high debt/equity (leverage) ratio versus low leverage ratio, borrowing in home currency versus borrowing in foreign currencies, and matching financing with types of assets by maturity (matching principle) or otherwise. A good financial strategist should consider number of factors such as the following:

Maturity Structure: Have you debt mature in different periods than within a year, and within a quarter in that year. The sudden cash outflow retiring several maturing debt loans (e.g., short-term loans, commercial paper, medium term loans, bonds, and other long-term loans), within one quarter, for instance, can force you to violate loan covenants and lead to insolvency. Hence, chart your loans by year of maturity (x-axis) and dollar size (y-axis), and study the pattern of your amortization.

Transaction Costs: While long-term debts involve fewer transactions, several short-term debts, even though cheap, may involve high transactions costs (e.g., paper work, commissions, opening costs, closing costs).

Flexibility: Short-term debt, however, is more flexible than long-term debt. If your business is seasonal, then you may prefer short term loans when you need cash, than go for long term loans that may result in idle surplus cash (cum accumulating interest) you may not need.
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
Uncertainty of securing loans: On the other hand, when you have long-term projects that involve long-term fixed and current assets, then you may prefer long-term borrowing for the project period than opt short-term loans that may not always to renewed given your mid-project performance conditions. Negotiating new loans or issuing new bonds at the end of each year can be very costly, especially if interest rates are volatile, your creditworthiness is fluctuating, and if your bank’s credit policies keep on changing in response to financial market turmoil.

The term structure of interest rates: Interest rates term structure relates to the schedule of interest rates you must pay depending upon the maturity (say, one, two, five or ten years) of your loans.
Chart number of years to maturity of your loans on the x-axis and corresponding interest rates on the y-axis, and study the “yield-curve.” For instance, your short-term interest rates may be lower than long-term interest rates. Often, attractive short-term rates may make you go for short-term loans. However, what if market conditions change (e.g., credit squeeze, high growth boom) and interest rates rise? Also, if all the borrowing are floating rate then the firm is vulnerable to rising interest rates, which often happen during recessions, and when sales revenue decline, thus increasing vulnerability of a cash crisis.
Keeping all these factors in mind, Table 4.14
charts different financial risk-reducing borrowing strategies. For instance, you can manage the risk of variable interest rates by balancing your long-term versus short-term borrowing. Three points you need to consider here:

Cost of borrowing (e.g., interest rates, transaction costs);

The risk of borrowing (e.g., changing interest rates, risk of future loan refusals), and

Type of assets you want to finance by borrowing (e.g., fixed assets such as buildings and machinery, permanent current assets such as cars, rentals, leases, utilities), or fluctuating current assets such as seasonal inventory, payroll, taxes, or entertainment).
Some firms follow the “matching principle” in which the maturity structure of the finance matches the maturity structure of the project or asset (see Table 4.14
).
Other things being equal, financing a business through borrowing is cheaper than using equity. This is because lenders require a lower rate of return than ordinary shareholders do. Moreover, finance providers of debt financial securities face lower risk, as they have a higher priority claim on the assets of the firm than shareholders in case of liquidation. Further, if the business is profitable, then debt interest can be offset against pre-tax profits, thus reducing corporate profits tax bill. Thirdly, issuing and transaction costs associated with raising and servicing debt are generally lower than for managing equity.
For these and other reasons, firms tend to finance company operations through more debt than equity – a phenomenon called financial gearing. Financial gearing concerns the proportion of debt in the capital structure. The terms gearing or leverage are interchangeable; the term gearing is common in Europe, while leverage is common in the USA. Various types of gearing are known:
Capital gearing
: the extent or proportion of a firm’s total capital is in the form of long-term debt – this is debt/equity ratio. This ratio indicates the firm’s ability to sell assets to repay long-term debt. A value of
0.33 implies that net assets are three times to offset long-term debt. This ratio is unreliable, if the market value of the assets is different (owing to depreciation, appreciation, obsolescence) to the book value of the assets. This ratio ranges from zero to infinity, thus making inter-firm comparisons meaningless. Hence, a bounded capital-gearing ratio is (long-term debt/[long-term debt + equity]). This ratio can also include short-term (e.g., term loans, overdraft), and medium term (e.g., commercial paper) borrowings. In which case the capital-gearing ratio is (all borrowings/[all borrowings + shareholders’ equity]). An even better
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capital-gearing ratio is [Long-term Debt/ Total market capitalization]. This ratio indicates the ability of the firm to sell stock to offset the threat of debt. All the capital gearing measures rely on the appropriate valuation of net assets either in the balance sheet or through due diligence. Obviously, net-asset evaluation is very challenging, as it is based on the evaluation of each of your assets (e.g., machinery, building, raw materials) and liabilities (e.g. short- and long-term debts, payables, bad debts, bad credit, write-downs). Some service agencies (e.g., advertising, consulting) may not have much assets. In which case capital gearing may not be a useful indicator for raising debt. With the dramatic shift from manufacturing to services, capital gearing based on asset valuation from balance sheets is becoming increasingly irrelevant.
Operating gearing : the extent or proportion of a firm’s total costs is financed by debt. You can gear various types of production costs such as pay roll, employee benefits, cost of raw materials, product design costs, warehousing costs, transportation costs, inventory costs, supply chain management costs, factory fire insurance, factory accident insurance, packaging and labeling costs, advertising and promotion costs, and the like. You can underwrite some of these costs by buying appropriate insurance policies. Of course, the more you break these costs and finance or insure them separately, the higher are transaction and insurance costs.
Income gearing : the extent or proportion of a firm’s total pre-interest profits is interest charges. Instead of focusing as net assets, income gearing focuses on the sources of income such as brands, brand equity, media creations, patents, intellectual property, human resources skills, and other intangibles, most of which do not feature on the company’s balance sheets. The value of great companies like Microsoft,
Disney, Marks & Spencer, and great advertising agencies is not based on their assets but on their intellectual pool of skills and software, media creations and brands.
Under such circumstances, balance-sheet gearing is no longer useful. One income gearing measure is
Interest Cover = Profits before interest and taxes/interest charges. Interest cover measures the proportion of profits paid out in interest. The lower the interest cover ratio the greater the chance of interest payment default and liquidation. Higher interest cover ratios, on the other hand, indicate how easy it is for companies to service their debts.
A company’s market capitalization (i.e., the total value at market prices of the outstanding shares of a company) reflects its intangible assets. Market capitalization overcomes the inadequacies if balance sheet measures of equity. Hence, another useful income-gearing ratio is to divide a company’s debt by its market capitalization. A higher ratio indicates that shareholders’ returns are more leveraged, and hence risky. A lower ratio signifies excellent performance by the company.
However, excessive gearing could lead to financial distress, especially if net cash flows are negative, then the company may find difficult to pay its bankers, bondholders and other creditors when such bills are due. That is, at low gearing levels the risk of financial distress is low, but the cost of capital (via equity) may be high. The opposite is true at high gearing levels, as long as the returns on equity are constant or do not rise with much with gearing.
A simple illustration : Company XYZ is planning to start a subsidiary business with four different gearing levels or capital structures for raising $20 million in capital: a) All equity – 10 million shares at IPO of $2.00. b) $5 million in debt (at 7% interest) and $15 million in equity. c) $10 million in debt (at 7% interest) and $10 million in equity. d) $15 million in debt (at 7% interest) and $5 million in equity.
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Obviously, gearing level increases from (a) to (d). We also assume that interest rates are independent of the debt-size, which may not be always realistic. Such sophistication, however, can be easily built into
Table 4.15
. In selecting a capital structure, the directors of Company XYZ project three scenarios as follows:
Moderate business success: Income before interest and taxes of $1.5 million with 25% probability.
Good business success: Income before interest and taxes of $3.0 million with 50% probability.
Great business success: Income before interest and taxes of $6.0 million with 25% probability.
Shareholder returns under each scenario and capital structure are presented in Table 4.15.
Table 4.15
assumes that interest on debt is tax deductible at 50%. As is clear from this table, given the projected business success estimates:

The shareholder returns at any level of projected business success are higher than the cost of capital rent (i.e., interest rate of 7%). That is, it pays to leverage debt.

The effect of gearing gets progressively better from capital structure (a) to (d), at all success levels and at the (probability weighted) expected level of project success. That is, shareholder returns keep increasing as gearing increases.

Increased gearing results in increased shareholder returns at all levels, modest, good and great, and weighted (expected) average. Hence, other things being equal, increased gearing reduces business and financial risk, and therefore, insurable risk.
Technically, one could even consider a 100% gearing capital structure as long as borrowing is available at a given interest rate, and in this case, there are no shareholders shares, and the owner of the business makes quasi-infinite profits.
Table 4.15
implies that firms with low business risk can take on relatively high levels of financial risk or gearing without reducing shareholder returns. Note, however, that while interest payments are tax deductible, dividends are not. Managers will generally increase the gearing level only if they are confident about the future. Upward changes in financial gearing can become a positive “signal” of managerial optimism to prospective shareholders, and hence, may lead to a rise in share price (Ross
1977).
On the other hand, had we projected a fourth and pessimistic “poor” scenario of $0.75 million EBIT with probability of, say 0.15, attached to it, then Table 4.15
would look quite different, and indefinite gearing would not be feasible for both the owner and the banker.
Table 4.16
presents various financial gearing ratios for different industries.
From an academic point of view, a business plan or model is a roadmap, a statement of strategy, an operational model, a business forecast or some other conceptual label. From an entrepreneur’s viewpoint, a business plan is a selling document, a sales pitch you give to prospective venture capitalists and banks.
A business plan does not sell a product or a service or a work environment, it sells an entire innovation project, the entire business venture or your new company. If you are really excited about and believe in your project or your new company, it should reflect in the business plan. Excitement, however, is not based on puffery or exaggeration. It is based on supporting evidence in the form of solid research and experience. The innovation, new product or service idea that you sell or form a company about should
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be real, credible, convincing, promising, attractive, demonstrable, and worth investing to your stakeholders. Hence, have a clear purpose, content, audience and expected outcome for your business plan. These will generate a sense of commitment, focus and realism to your document.
According o Johnson, Christensen and Kagermann (2008), a business model consists of four interlocking elements that, taken together, create and deliver value: a) Customer value proposition, b)
Profit formula, c) Key resources, and d) Key processes. These four elements form the building blocks of any business. The first two elements define value for the customer and the company, and the last two describe how the company will deliver that value to the customers and the company, respectively. Profit formula is not the same as the business model; the former is just a piece of the latter. Start by setting the price required to deliver the CVP and then determine backwards what should be the variable and fixed costs should be and he gross margins. In other words, do not start with a cost-driven price (e.g., cost-plus, mark-up) but a price-driven cost. Thus, you avoid the third deadly sin of executives, according to Peter
Drucker (1996).
Customer Value Proposition (CVP): A successful company is one that has found a way to create and deliver value to customers. The most important attribute of a CVP is its precision – how perfectly it identifies the customer need or nails he customer job to be done. Value relates to helping customers to get an important job done. Job relates to a fundamental problem to which the customer needs an effective solution, and better than existing solutions. The more important the job is, the higher is customer expectation, the lower is customer satisfaction with existing solutions, and hence, the higher is CVP. Design and deliver your product/service to do that important job. CVP is the most important part of the business model.
In precisely defining customer need or job or CVP, one may consider four constraints that shape and cause needs: insufficient buying power, access, skills and time. For instance, software maker, Intuit, devised QuickBooks to fulfill the needs of small business owners’ to avid running out of cash.
QickBooks greatly simplified existing accounting packages that needed sharper skills. Similarly,
MinuteClinic, the drug-store based healthcare provider, that made nurse practitioners available without appointments, broke the time barrier that kept people from visiting doctor’s offices with minor health issues.
Profit Formula: this is a blueprint how the company creates value for itself while providing value to the customer. The profit formula has several sub-components:
1.
Revenue model: basically, price that the market bears multiplied by the volume you want to offer at that price.
2.
Cost Structure: relates to direct or variable costs, fixed or indirect costs, and the economies of scale. The key resources primarily determine the cost structure.
3.
Margin Model: Given the expected volume and cost structure, what is the contribution margin that the company needs from each transaction?
4.
Resource Velocity: how fast do we need to turnover inventory, fixed costs and utilize other key resources to support our expected volume, cost structure, and profits?
Key Resources: these are assets such as key skills, brand equity, technology, new products, new equipment, channels and brand names required to create and deliver value to the target customers and the company. Having articulated the value proposition for the customer and the business, companies must next consider the key resources and processes needed to deliver that value. Key resources are those that create competitive differentiation.
Key Processes: Successful companies have operational and managerial processes that deliver value
(e.g., training and retraining employees, strategic planning, sales planning, budgeting, forecasting, market scanning, organizational routines, performance metrics, company mores and codes of conduct, inventory management skills, new product development skills, production skills, packaging
38

and product bundling skills, promotional skills, and channels) that enable them to deliver value to the customer and the company.
This four-component business model is simple. Its power lies in the complex interdependencies of its parts. Major changes to any of these four elements affect the others and the whole. Successful businesses weave a more or less stable system in which these elements bond to one another in consistent and complementary ways. Often, it is not the individual key resources and processes that make the difference but their relationship to one another. Companies need almost always to integrate their key resources and processes in a unique way to get a job done perfectly for a set of customers. This integration ensures differentiation and sustainable competitive advantage. For instance, National Jewish Health in Denver organizes itself around a unique CVP – pulmonary disorder cure. Narrowing its focus has allowed NJH to develop key resources and processes to deliver a unique CVP very effectively and profitably. Similarly, the Tata Nano fulfills a specific job for scooter/motorcycle families – a cheap, safe and all-weather family transport. The young group of engineers that designed Nano dramatically minimized the number of parts in the vehicle, resulting in significant cost savings (Johnson, Christensen and Kagermann 2008: 53-55).
You do not need a new business model if you can fulfill CVP and value to your company with your existing model. Otherwise, invent a new business model when the opportunity is large enough to justify the effort of changing a business model. Pursuing a new business model that is not new to the company or the market or game-changing to the industry is a waste of time and money. Creating a new business model for a new business does not mean that the current one is threatened or should be changed. A new model often reinforces and complements the core business. For instance, when there are significant changes to the four components of a business model, then we need to innovate or reinvent the business model. A new business model may be more efficient if you are dealing with an entire new CVP, a new business process, a new key resource, or just to disrupt your competitors. Johnson, Christensen and
Kagermann (2008: 57-59) observe five strategic circumstances that often mandate a new business model:
1.
The opportunity to reach larger markets: Some customers have no access to existing products or services as they cannot afford them. Under such circumstances, we need business models that can democratize such products or services in emerging markets so that larger masses can benefit from them (e.g., the case of Ford Model T in 1907, Tata Model Nano in 2008).
2.
The opportunity to capitalize on a brand new technology: One can wrap a new business model around it (e.g., Apple’s iPod and iTunes around MP3 technology of file sharing); this opportunity can also extent to leveraging a tested technology by bringing it to a whole new market (e.g. commercializing the Internet in 1993; using military technology to commercial use as GM’s use of GPS, or Hummer
I, II and III).
3.
The opportunity to bring a job-to-be-done focus when one does not exist: For instance, when FedEx entered the package delivery market, it did not compete with USPS or UPS through lower prices or better marketing, but focused on an entirely unmet market need of receiving packages faster, more reliably and predictably than did USPS, UPS or any other competitor. FedEx had a considerable competitive advantage in doing just this job; it took years for USPS and UPS to catch with FedEx.
4.
The need to fend-off low-end disrupters: For instance, if the Nano is successful it will disrupt the regular automakers; the mini steel mills disrupted the big integrated steel companies; Cemex the mini cement-concrete manufacturer rocked the big suppliers.
5.
The need to respond to a shifting basis of competition: an acceptable solution in a market will change over time, inviting core market segments to commoditize the solution. The need for tissue transplant,
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organ transplant and surrogate motherhood is getting to be highly commoditized. Home Depot commoditized hitherto complex home improvement products.
Successful new businesses typically revise their business models four times or so, on the road to profitability. While a well-considered business-model-innovation process can often shorten this cycle, successful incumbents must accept and tolerate initial failure and proceed to correct the process learning from one’s mistakes. Companies have to focus on both learning and executing. A profitable business is the best early indication of a viable business model. Truly transformative successful businesses are never exclusively about the discovery and commercialization of new technology; their success comes from enveloping the new technology in an appropriate and powerful business model
Any business plan must take into account uncertainty and the volatility of the markets in which the corporation is engaging. Successful executives that cut their teeth in stable and predictable industries or in developed countries often stumble when entering more volatile markets of the developing world. They mistakenly believe they can foresee and control the deep future and draft a long-term strategy that will ensure them sustainable competitive advantage. However, visibility in volatile markets is sharply limited owing to many uncontrollable and unknown variables in play. Many variables are individually uncertain, and they interact with one another to create unexpected outcomes. Managers in turbulent markets cannot control the timing either of the rare golden opportunity or the equally rare sudden death-threat. These events are clear in retrospect, but impossible to predict. Knowing what to do during periods of relative calm can spell the difference between industry leadership and extinction (Sull 2005:121-123).
Business model innovations have reshaped entire industries and redistributed billions of dollars of value. Wal-Mart and Target entered the discount retailing market with pioneering business models against the founder and first mover K-Mart, but now account for nearly 75% of the U. S. retailing sector.
Similarly, some 11 low-cost U. S. airlines that sprung during the last quarter of a century now control
55% of the air dollar traffic and have made their into Fortune 500 during the last ten years – they had great business model innovations.
“Established companies do not succeed with radically new product offerings unless they understand exactly how the opportunity relates to their current business model and proceed accordingly” (Johnson,
Christensen and Kagermann 2008: 53). A business model should start by a strong customer value proposition. Then constrict a profit formula that can deliver value to your company. Then decide upon key resources and processes that you will need to deliver the value to the customer and the company.
Many companies start with a product and a business model and then go in search of a market. Real success comes from figuring how to satisfy a real customer need or a job that the customer wants done.
The product and the business model should be dovetailed to the customer need. It is not possible to invent or reinvent a business model without first identifying a clear customer value proposition.
When Ratan Tata of the Tata Group saw thousands of scooters and motor cycles in heavy Mumbai traffic carrying literally the whole family with them, he saw a need for a safer, all-weather alternative for scooter and motorcycle families. Typical cars cost at least five tines the value of scooters or motorcycle.
These families could not afford that. Hence, the Tata Group devised a small car safe and cheap enough to carry them safely, and the $2,500 Nano car was born. That was a car the customer could afford – it was less than half the price of the cheapest car then available, but about 25%-50% more than that of an ordinary scooter or motorcycle. The Tata Group had to change the cost structure radically in order to make Nano profitable. It required both a significant drop in gross margins and a radical reduction in many elements of the cost structure. The company knew it could still make money if it could increase sales
40

volume dramatically. A team of young engineers developed new processes – outsourcing 85% of the car components, using 60% fewer vendors, and eventually employing a network of assemblies to build to order. The rest is history.
In 2003, Apple introduced the iPod followed by the iTunes, revolutionizing portable entertainment, creating a new market, and transforming the company. By 2006, the iPod/iTunes bundle became a $10 billion product, accounting for almost 50% of Apple’s revenue. Apple’s market capitalization skyrocketed from around $1 billion in early 2003 to over $150 billion by late 2007 (an annual compound growth rate of nearly 250%). Apple, however, was not the first to bring digital music players to the market. Diamond Multimedia introduced the Rio in 1998, and Best Data launched the Cabo 64 in 2000; both were good and stylish products of portable entertainment. While the latter two failed, Apple succeeded. The reason: Apple had a brilliant business model that backed its products. Apple’s true innovation was to make downloading digital music easy and convenient. To do that, Apple built a groundbreaking business model that combined hardware, software, and service. This approach worked like Gillette’s famous blades-and-razor model in reverse: Apple essentially gave away the “blades” (low margin iTunes music) to lock in purchase of the “razor” (the high margin iPod). The business (product bundling) model defined value in a new way and provided game-changing convenience to the consumer.
Every successful company operates according to an effective business model. By systematically identifying all of its constituent parts, executives can understand how the model fulfills a potential customer value proposition in a profitable way using certain key resources and key processes (Johnson,
Christensen and Kagermann 2008: 51-54).
Arnold, Glen (2007), The Handbook of Corporate Finance: A Business Companion to Financial Markets, Decisions and Techniques , Financial Times: Prentice Hall.
Bonabeau, Eric, Neil Bodick and Robert W. Armstrong (2008), “A More Rational Approach to New Product
Development,” Harvard Business Review , (March), 96-102.
Buehler, Kevin, Andrew Freeman and Ron Hulme (2008a), “The New Arsenal of Risk Management,” Harvard
Business Review , (September), 93-100.
Buehler, Kevin, Andrew Freeman and Ron Hulme (2008b), “Owning the Right Risks,” Harvard Business Review ,
(September), 102-110.
Bygrave, William D. (Ed) (1997), The Portable MBA in Entrepreneurship , 2 nd edition, John Wiley & Sons.
Gumpert. David E. (1997), “Creating a Successful Business Plan,” in
The Portable MBA in Entrepreneurship,
Bygrave, William D. (ed), 2 nd edition, John Wiley & Sons.
Johnson, Mark W., Clayton M. Christensen, and Henning Kagermann (2008), “Reinventing your Business Model,”
Harvard Business Review , (December), 50-59.
Megginson, William L., Mary Jane Byrd, Charles R. Scott and Leon C. Megginson (1994), Small Business
Management: An Entrepreneur’s Guide to Success , Burr Ridge, IL: Irwin.
Merton, Robert (2005), “You have more Capital than you Think,” Harvard Business Review , (November), 84-94.
Royer, Isabelle (2003), “Why Bad Projects are so Hard to Kill,” Harvard Business Review , (February), xx-xx.
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Business Factors
The Proposed
Product
Its expected target market
The strengths and weaknesses of the industry
Production methods and facilities
Financing aspects
Marketing policies and strategies
Distribution
Profitability
Dimensions Company
Objectives
Timeframe for achieving objectives
Its nature: what is it? How does it work?
Its domain: attributes, features, benefits
Its industry: nature, scope, newness
Satisfaction of need, want or desire
The target market: local, national, global
Its current market: size, buying power
Augmented market: growth rate
Any new market? New use? New options?
Stagnant industry? Trends, cycles
Vibrant industry? competition
Future growth? Local, national, global
Converging industry? Digitizable?
Expanding industry?
Quality materials and costs?
Quality parts and costs?
Quality components and costs?
Quality design and costs?
Quality engineering and costs?
Quality packaging and costs?
Quality bundling and costs?
Scaling and scope economies?
Required labor skills
Estimated total costs
Range of total costs
Cost contingencies
Potential investors? How to raise funds?
Innovation intermediaries?
Bank loans?
Product bundling, branding
Price bundling, price signals
Pricing, costing, mark-ups
Premium pricing
Penetration pricing
Competitive pricing
Discount pricing
Promoting; free sample use/test
Advertising
Warehousing and inventory mgmt
Transportation logistics
Shipping and tracking
Distribution channels and retailing outlets
Slotting allowances
Shelving & POP display
Sales revenue in one, two or three years?
Cost of good sold in one to three years?
Gross margins in the first 3 years?
Marketing and selling expenses
Contribution margin
Administrative overhead
Net contribution margins
Retained earnings
ROQ, ROS, ROM, ROI, ROE, ROA,
EBIT, EBITD, EBITDA, EBITDAR
Free cash flow analysis
Net present value of earnings
Barriers to goals and how they can be overcome?
43

Sales
Sales revenues
Controllable or variable expenses
Cost of good sold
Gross profit
Salaries
Wages
Payroll taxes
Office furniture
Office supplies
Telephone
Utilities
Shipping and handling
Postage
Newspapers
Trade magazines
Legal and accounting
Advertising
PR
Miscellaneous
Fixed expenses
Cars
Trucks
Insurance
Profitability EBIT
Rent and lease
Tax and license
Interest on debt
Amortization
Depreciation
EBITD
EBITDA
EBITDAR+
* Projected profit and loss statements can be done by each month, each quarter, or each year.
+ Earnings before interest, taxes, depreciation, amortization and rents.
44

Items
Beginning cash:
Cash
Cash equivalents
Total Cash
Receipts:
Cash sales
Loans
Other cash
Total Receipts
Variable Expenses:
Salaries
Wages
Payroll taxes
Material purchases
Office furniture
Office supplies
Telephone
Utilities
Shipping & handling
Postage
Newspapers
Trade magazines
Legal & Accounting
Advertising
PR
Miscellaneous
Total VE
Fixed Expenses:
Insurance
Cars lease
Trucks lease
Rent and lease
Tax and license
Interest on debt
Amortization
Total FE
Capital
Expenditures:
Computers
IT Infrastructure
Technologies
Licenses
Total CE:
Total Expenditures
Ending Cash
Startup
04/08
500
500
2,000
500
3,500
5,000
5,000
2,000
12,000
43,175 10,934
26,825 27,891
1,825
25,000
26,825
10,000
10,000
3,000
2,000
600
1,000
100
100
200
50
250
100
7,400
200
500
500
2000
334
3,534
2,500
1,000
1,000
500
100
125
200
750
500
500
500
27,675
50,000
20,000
70,000
20,000
05/08
200
500
500
2,000
334
3,534
2,891
25,000
27,891
12,000
12,000
3,000
2,500
660
1,200
100
120
100
50
250
150
7,980
200
500
500
2,000
334
3,534
250
500
500
06/08 07/08 08/08 09/08 10/08 11/08 12/08 01/09 02/09 03/09
200
500
500
2,000
334
3,534
250
200
500
500
2,000
334
3,534
250
200
500
500
2,000
334
3,534
250
500
500
200
500
500
2,000
334
3,534
250
200
500
500
2,000
334
3,534
250
200
500
500
2,000
334
3,534
250
500
500
200
500
500
2,000
334
3,534
250
200
500
500
2,000
334
3,534
250 250
500
500
200
500
500
2,000
334
3,534
45

(Year ending March 31, 2009 )
Item
Sub-item
Cash
Marketable securities (at cost)
Accounts receivable
Inventories
Prepaid rent
Prepaid lease
Total Current Assets
Land
Building
Machinery and plant
Office Equipment & Supplies
Less: Accumulated depreciation
Net Fixed Assets
Prepayment & deferred charges
Intangible
March 31, 2009 March 31, 2010 March 31, 2011
5,500
25,000
30,000
21,000
2,000
0
6,600
30,000
36,000
25,200
2,400
2,400
8,085
36,750
44,100
30,870
3,000
3,000
83,500
3,500
4,500
10,000
18,000
102,600
4,200
5,400
12,000
21,600
125,805
5,145
6,615
14,700
26,460
Accounts payable
Notes payable (current portion)
Accrued interest payable
Accrued wages payable
Accrued income taxes payable
Other expenses payable
Total Current Liabilities
12,500
2,500
1,000
2,500
2.500
21,000
15,000
3,000
1,200
3,000
3,000
25,200
18,375
3,675
1,470
3,675
3,675
30,870
Long term loans
Deferred taxes
50,000
1,000
72,000
40,000
2,500
67,700
30,000
2,000
62,870
Common Stock (e.g., $5 a share,
Authorized 10,000 shares)
Capital surplus
Accumulated retained earnings
Dividends
Total Shareholders’ Equity
20,000
9,500
29,500
40,000
16,500
56,500
50,000
24,395
15,000
89,395
46

(All figures in $s)
Cash
Marketable Securities (at cost)
Accounts receivable less allowance for bad debts
Inventories
Prepaid rent
Total Current Assets
Land
Building
Machinery and Plant
Office equipment and supplies
Less: Accumulated depreciation
Prepayment and deferred charges
Intangibles
Accounts payable
Notes payable (current portion)
Accrued interest payable
Accrued wages and other expenses payable
Accrued income taxes payable
Long term liabilities:
First mortgage bonds (5.5% interest, due 2020)
Deferred taxes
Stockholders’ Equity:
Common stock, $5 par value each; authorized, issued, and outstanding 300,000 shares
Capital surplus
Accumulated retained earnings
175,000
175,000
700,000
1,045,000
5,000
2,100,000
157,500
1,400,000
525,000
17,500
700,000
1,400,000
140,000
35,000
3,675,000
350,000
515,000
10,000
87,500
87,500
1,050,000
1,050,000
210,000
2,310,000
525,000
175,000
665,000
1,365,000
3,675,000
262,500
165,000
10,000
78,750
78,750
595,000
1,050,000
210,000
1,855,000
525,000
175,000
437,500
1,137,500
2,992,500
175,000
157,500
560,000
700,000
---
1,592,500
157,500
1,400,000
280,000
17,500
595,000
1,260,000
105,000
35,000
2,992,500
0%
11.11%
25.00%
49.29%
---
31.86%
0.00%
0.00%
87.5%
0.00%
17.64%
11.11%
33.33%
0.00%
22.81%
33.33%
212.12%
0.00%
11.46%
11.46%
76.47%
0.00%
0.00%
24.53%
0.00%
0.00%
52.00%
20.00%
22.81%
47

(All figures in $s)
Net sales
Cost of goods sold
Gross profit (or gross margin)
Gross profit as percentage of sales
Operating expenses:
Wages
Rent
Miscellaneous
Depreciation
Total operating expenses
Operating income (or operating profit)
Operating profit as a percentage of sales
Selling and administrative expenses
Operating Profit (EBIT)
Operating Profit as percentage of sales
Other Income:
Dividends and interest
Total Incomes from Operations
Less: Interests on bonds and other liabilities
Income before taxes
Provisions for income tax
Net Profit after interest and taxes (NPAIT)
NPAIT as percentage of sales
Dividends paid out
Dividends as percentage of sales
Retained earnings
Retained earnings as percentage of sales
17,500
577,500
105,000
472,500
213,500
259,000
6.45%
31,500
0.78%
227,500
5.65%
4,025,000
2,000,000
2,025,000
51.31%
800,000
50,000
20,000
105,000
975,000
1,050,000
26.09%
490,000
560,000
13.91%
495,600
13.23%
17,500
513,100
52,500
460,600
210,000
250,600
6.69%
46,200
1.23%
204,400
5.46%
3,745,000
1,909,400
1,835,600
49.01%
700,000
50,000
30,000
96,250
876,250
959,350
25.62%
463,750
7.48%
4.74%
10.32%
2.30%
14.29%
0.00%
-33.33%
9.09%
11.27%
9.45%
0.47%
5.66%
12.99%
0.68%
0.00%
12.55%
100.00%
2.58%
0.76%
3.35%
-0.24%
-31.82%
-0.45%
11.30%
0.19%
48

Cash Flow from
Operations
Net Income during 2003
Increase in depreciation over 2002
Total Cash Flow from Operations
Decrease in net working capital
Increase in accounts payable over 2002
Increase in notes payable over 2002
Increase in interest payable over 2002
Increase in accrued wages & other expenses payable over
2002
Increase in taxes payable over 2002
Total Sources of Cash
During 2003
Increase in fixed assets Investments in land over 2002
Investments in building over 2002
Investments in machinery and plant over 2002
Investments in office equipment and supplies over 2002
Total increase in fixed assets over 2002
Increase in other assets Increase in prepayments and deferred charges over 2002
Increase in intangibles over 2002
Dividends paid in 2003
Increase in net working capital
Increase in inventory over 2002
Increase in accounts receivable over 2002
Increase in marketable securities over 2002
Increase in prepaid rent over 2002
Total Uses of cash
During 2003
Change in cash balance
During 2003
Total sources of cash minus total uses of cash
259.00
105.00
364.00
87.50
350.00
0.00
8.75
8.75
819.00
0.00
0.00
245.00
0.00
245.00
35.00
0.00
31.50
345.00
140.00
17.50
5.00
819.00
0.00
49

Buying raw materials
Paying for the raw materials bought
Manufacturing the product
Selling the product
Retailing the product
Collecting cash from retailers or customers
From whom to buy?
How much inventory to order?
Just-in-time inventory?
When to order?
At what price?
With what trade terms?
Purchase against cash?
Purchase on credit?
Purchase on debit?
Part payment?
Prepayment?
Borrow money for payment?
Draw down cash balance to pay?
Which specific product to produce?
Which specific brand to produce?
With what process technology?
With what production technology?
With which core competences?
Which employee skills to tap?
How much to produce?
How to size the product?
How to brand or label the product?
When to produce?
How to manage the inventory?
How do distribute the product?
How to pre-announce the new product?
How to promote the product?
How to advertise the product?
How to price the product?
What price discounts?
What rebates?
What financing arrangements?
What guarantees and warranties?
Selling exclusively through retailers?
In which retail outlet types?
Upscale? Middle-scale? Discount stores?
Urban versus rural stores?
In big versus medium versus small cities or towns?
Pay slotting allowances (i.e., buy selling space in the store)?
Sell products on consignment (i.e., collect cash after sale)?
Sell on credit to the retailers?
Provide selling incentives to retailers?
How to collect cash?
When to invoice?
Request payment within how many days from invoice?
Request prepayment in full or in part?
Request full payment on receiving the product?
Request full payment within 30 days of invoicing?
50

a) Opportunity costs: for alternative use of money invested in current assets such as high levels of cash, accounts receivable and marketable securities. b) Costs of maintaining assets
economic value: e.g., warehousing, inventory management and sunk capital costs in high inventories.
a) Trading or order costs: costs of placing frequent orders
(brokerage costs) and production set-up costs when maintaining low inventories. b) Costs related to safety reserves: costs of lost sales, lost customer goodwill when running short of product inventories, and disruption of production schedules.
TC = Total costs (carrying costs + shortage costs) of holding current assets.
ICA = Investments in current assets such as cash, marketable securities, accounts receivable, and inventories.
51

Operating
Activities
Investing
Activities
Financing
Activities
(See Horngren, Sundem and Elliott 2002: 411)
Sales of goods and services for cash
Sales of goods and services on credit
Receive dividends, rent or interest
Collection of accounts receivable
Recognize cost of goods sold
Purchase inventory for cash
Purchase inventory on credit
Purchase machinery for cash
Purchase machinery for credit
Pay trade accounts payable
Accrue operating expenses
Pay operating expenses
Accrue taxes
Pay taxes
Accrue interest
Pay interest on long term debt
Prepay expenses for cash
Write off prepaid expenses
Charge depreciation or amortization
This year’s tax liability is increased
Purchase fixed assets for cash
Purchase fixed assets by issuing long-term debt
Purchase fixed assets by issuing short-term debt
Sell fixed assets for cash
Sell fixed assets for credit
Purchase marketable securities from retained earnings
Purchase securities that are cash equivalents
Purchase securities that are not cash equivalents
Sell securities that are not cash equivalents
Make a loan
Increase long-term debt
Increase short-term debt
Reduce long term debt
Reduce short-term debt
Sell common or preferred stock
Repurchase and retire common or preferred stock
Purchase treasury stock (marketable securities)
Pay dividends
Convert debt to common stock
Reclassify long-term debt to short-term debt
Allowance for bad debt is decreased
Inflows
Inflows
Outflows
?
Outflows
Outflows
Outflows
Outflows
Inflows
Inflows
Outflows
Outflows
Outflows
Inflows
Outflows
Inflows
Inflows
Inflows
Outflows
Outflows
Outflows
Outflows
Outflows
Outflows
Outflows
Outflows
Outflows
Outflows
Outflows
Outflows
Inflows
Inflows
Outflows
Outflows
Inflows
Outflows
Outflows
Outflows
Inflows
Outflows
?
Positive
None
None
None
Negative
Negative
None
None
Positive
None
Negative
Positive
Negative
Positive
Negative
Positive
Positive
None
Negative
None
Negative
None
Negative
None
Negative
None
Negative
None
Negative
Negative
Positive
Positive
Negative
Negative
Positive
Negative
Negative
Negative
None
None
None
52

Activities
Table 4.11: Computing Cash Flows from the Balance Sheet and Income Statement of XYZ Manufacturing Inc.: Direct Method
(All figures in $000)
Δ in
Cash =
Change in Liabilities
Δ in + Δ in + Δ in
Current
Liabilities
Longterm
Debt
Stockholders’
Equity
Change in Assets
- Δ in
Noncash
Current
Assets
- Δ in
Fixed
Assets
Operating Activities
1. Sales on credit + 4,025.00 -4,025.00
2.* Collection of AR
3. Recognition of CGS
4. Inventory purchases on account
5.* Payments to suppliers
6. Wages and salaries expense
7.* Payment to Employees
8.* Amount of taxes paid
9.* Rent paid
10.* Miscellaneous expenses
11.* Prepaid rent
12* Selling and Administrative
Expenses paid
13. Expenses not requiring cash: depreciation
14.* Other income: Dividends from company’s investments and interest from company’s loans
15.* Interests on bonds and other liabilities paid
Net cash provided by operating activities
+3,885.00
- 2,257.50
- 791.25
- 204.75
- 50.00
- 20.00
- 5.00
- 490.00
+ 17.50
- 105.00
- 21.00
+2,345.00
-2,257.50
+ 800.00
- 800.00
+ 4,025.00
- 2,000.00
- 800.00
-213.50
- 50.00
- 20.00
- 5.00
- 490.00
- 105.00
+ 17.50
- 105.00
-140.00
- (- 2,000.00)
- (+2,345.00)
+ 8.75
+ 8.75
- (- 105.00)
16.* Acquisition of fixed assets
17.* Disposal of fixed assets
18.* Prepayment and deferred charges
19.* Change in intangibles
Net cash provided by investing activities
20.* Issuing long term-debt
21.* Issuing common stock
22.* Dividends paid
23.* Increase in notes payable
24.* Increase in marketable securities
Net cash provided by financing activities
Net changes in cash
- 245.00
0.00
- 35.00
0.00
- 280.00
0.00
0.00
- 31.50
+ 350.00
- 17.50
+301.00
00.00
+ 350.00
+ 437.50
0.00
0.00
0.00
- 31.50
+ 4,247.50
- 17.50
- 4,510.00
- (+ 245.00)
0.00
- 35.00
0.00
- 175.00
53

Operational Activities:
Positive cash flows
Operational Activities:
Negative cash flows
Net Income
Depreciation
Net increase in accounts payable
Net increase in wages payable
Net increase in taxes payable
Total positive operational cash flows
Net increase in accounts receivable
Net increase in inventory
Net increase in prepaid rent
Total negative operational cash flows
259,000
105,000
87,500
8,750
8,750
+ 469,000
140,000
345,000
5,000
Net operational cash flows
Investing Activities:
Positive cash flows
Investing Activities:
Negative cash flows
No activities
Net increase in machinery and plant
Net increase in prepayment and deferred charges
Total negative investing cash flows
- 490,000
- 21,000
245,000
35,000
Net Investing cash flows
Financing Activities:
Positive cash flows
Financing Activities:
Negative cash flows
Net Financing cash flows
Total Activities Net Cash
Flows
Net increase in notes payable
Net increase in dividends paid
Net increase in marketable securities
Total negative financing cash flows
- 21,000 - 280,000 + 301,000 =
- 280,000
- 280,000
350,000
31,500
17,500
- 49,000
+ 301,000
00.00
54

1
2
3
4
5
6
7
8
Operating
Activities
(OA)
Investing
Activities
(IA)
Financing
Activities
(FA)
+
+
+
+
-
-
-
-
+
+
-
-
+
+
-
-
+ Companies in old and viable industries with still good profitable opportunities generate positive cash flows from their operations (hence + OA cash flows), but continuously dispose old fixed assets or sell securities that are not cash equivalents (hence, + IA cash flows), but can still attract much cash from investors in terms of stock, bonds, and long-term debts (hence, + FA cash flows).
(E.g., All U. S. auto companies like the Big Three)
- Companies in old and phasing out industries with little profitable opportunities generate positive cash flows from their operations (hence + OA cash flows) while selling fixed assets and securities that are not cash equivalents (hence, + IA cash
+ flows) and reducing long term debt, retiring common and preferred stock or pay heavy dividends with no retained earnings (hence, - FA cash flows). (E.g., most steel and railroad companies in the U. S.)
Companies in young and dynamic industries with good profitable opportunities generate positive cash flows from their operations (hence, + OA cash flows), but continuously invest much cash or debt on new fixed assets (hence, - IA cash flows) and attract much cash from investors in terms of stock, bonds, and longterm debts (hence, + FA cash flows). (E.g., Wal-Mart, Dell, Microsoft, IBM, and homebuilder companies)
- Companies that are growing more slowly with some good profitable opportunities, generate enough cash from their operations (hence + OA cash flows) to invest in new fixed assets while maintaining old ones (hence, - IA cash flows), but keep on reducing long term debt, repurchase or retire common or preferred stock and purchase marketable securities for cash equivalents (hence,
-FA cash flows). (E.g., most fast food competing companies in the US:
McDonalds, Domino Pizza, Taco Bell).
+ Companies in old and speculative or high-risk industries with uncertain profitable opportunities, currently generate no profits from their operations
(hence - OA cash flows), but, regularly raise cash by selling older assets (hence, +
IA cash flows), and still qualify for long-term debt and equity (hence, + FA cash flows). (E.g., hospitals, hotels, casinos, and resort companies)
- A shrinking firm with decreasing sales (hence, - OA cash flows) and realizing cash from the sale or retirement of assets (hence, + IA cash flows), but not doing well in operations and in attracting new capital (hence, - FA cash flows). (E.g., any firm that is either failing or insolvent).
+ Companies that are young and in new industries may be currently unprofitable in their operations (hence, - OA cash flows), but continuously invest much cash on new fixed assets and acquisitions (hence, - IA cash flows), but are able to attract good venture capital from high-risk investors (hence, + FA cash flows).
(E.g., several new dot.com companies that survived the 2000 crash).
- Companies in trouble: no positive cash flows or profits from operations (hence, -
OA cash flows), but trying to bail out by venturing into new acquisitions, joint ventures or fixed assets (hence, - IA cash flows) and failing to attract new investors while paying off old debts (hence, - FA cash flows). (E.g., Enron,
Kmart, Tyco, World.Com)
55

When interest rates are expected to rise
When interest rates are fluctuating and expected to rise or fall
When interest rates are fluctuating and expected to fall
When interest rates are fluctuating and expected to fall, costs of transactions are low, and risk of borrowing is low.
56

(p = 0.25)
$1.5 million
(p = 0.50)
(p = 0.25)
$3.0 million $6.0 million $3.375 million Earnings before interest and taxes
Interest on debt at
7%
Tax write-off on interest at 50%
Earnings available for shareholders
Returns on
Company XYZ shares
Interest on debt at
7%
Tax write-off on interest at 50%
Earnings available for shareholders
Returns on
Company XYZ shares
Interest on debt at
7%
Tax write-off on interest at 50%
Earnings available for shareholders
Returns on
Company XYZ shares
Interest on debt at
7%
Tax write-off on interest at 50%
Earnings available for shareholders
Returns on
Company XYZ shares
0.0
0.0
$1.5 million
$1.5M/$20M =
7.5%
$0.35M
$0.175M
$1.325M
$1.325M/$15M
= 8.833%
$0.70M
$0.350
$1.15M
0.0
0.0
$3.0 million
$3.0M/$20M
= 15.0%
$0.35M
$0.175M
$2.825 M
$2.825/$15 =
18.833%
$0.70M
$0.350
$2.65M
0.0
0.0
$6.0 million
$6.0M/$20M
= 30.0%
$0.35M
$0.175M
$5.825M
$5.825/$15M
= 38.833%
$0.70M
$0.350
$5.65M
$1.15M/$10M =
11.50%
$2.65M/$10M
= 26.50%
$5.65M/$10M
= 56.50%
$1.05M
$0.525
$0.975M
$0.975/$5M =
19.50%
$1.05M
$0.525
$2.475M
$2.475M/$5M
= 49.50%
$1.05M
$0.525
$5.475M
$5.475M/$5M
= 109.50%
0.0
0.0
$3.375 million
$3.375M/$20M
=16.875%
$0.35M
$0.175M
$3.200M
$3.200/$15M =
21.333%
$0.70M
$0.350M
$3.025M
$3.025M/$10M
=30.25%
$1.05M
$0.525M
$2.850M
$2.850M/$5M
=57.00%
57

[Source: Derived from Smart, Megginson and Gitman 2007: 456)
Microsoft
Cisco Systems
Intel
Dell
Exxon Mobil
Computer software
Computer systems
Semiconductors
Computer hardware
Integrated petroleum
Pharmaceuticals Johnson &
Johnson
AOL Time
Warner
Coco Cola
Entertainment/medi a
Consumer products
Delta Airlines Airline
Verizon Common Telecommunications
BellSouth Telecommunications
General Electric Conglomerate
Georgia Pacific
GMC
Caterpillar
Forest products
Auto manufacturing
Construction equipment
Debt/
Total
Assets
(Book
Value)
0.0
0.0
0.03
0.04
0.07
0.08
0.11
0.12
0.36
0.36
0.39
0.40
0.49
0.51
0.53
Debt/Total
Assets
(Market
Value)#
0.0
0.0
0.01
0.01
0.04
0.02
0.29
0.04
0.77
0.36
0.23
0.44
0.69
0.84
0.50
Long-term
Debt/Total
Capital @
(Book
Value)
0.0
0.0
0.03
0.10
0.09
0.08
0.13
0.10
0.69
0.58
0.45
0.59
0.68
0.89
0.67
Long-term
Debt/Total
Capital
(Market Value)
0.0
0.0
0.01
0.01
0.03
0.01
0.29
0.02
0.75
0.26
0.17
0.17
0.55
0.83
0.35
Ford Auto manufacturing 0.60 0.84 0.96 0.84
# Total liabilities (book value) divided by the market value of equity plus the book value of debt.
@ Long term debt (book value) divided by the sum of the market value of equity and the book value of long-term debt.
* Per share price of company common stock divided by the per share book value of shareholders’ common equity.
Market to
Book
Ratio*
5.54
3.94
4.03
14.87
3.72
7.32
0.74
4.24
12.85
0.82
3.63
3.18
5.38
1.19
4.12
2.52
58

Problem: As an entrepreneur, you need to buy your factory cum office space. You have cited a good place available for $120,000. The following terms apply: upfront cash down $20,000. Annual mortgage rate is 12 percent, or a monthly rate of one percent. If you wish amortize the remaining capital debt of $100,000 in equal monthly installments of X dollars for the next ten years, then a) what is X, b) what are your total cash disbursements, and c) what is your total capital rent?
Assume: 1) the first X is paid a month after the initial cash down payment of $20,000, and 2) the mortgage annual rate of 12 percent is fixed for the next ten years.
Procedure: The first X paid a month after the cash down has the following effect on the remaining capital debt P = $100,000.
Let r be the monthly interest rate.
Then, after the first payment of X, your total debt is P(1 + r) – X (1).
After the second payment of X, your remaining total debt is:
= [P(1+r) – X] – X + [P(1+r) – X]r
= [P(1+r) – X] (1+r) – X
= P(1+r) 2 - X(1+r) – X
[Augmented debt] minus [first payment + accrued interest] minus [second payment] (2).
After the third payment of X, your remaining total debt is:
= P(1+r) 3 - X(1+r) 2 - X(1+r) – X (3).
[Augmented debt] minus [first payment minus [second payment minus [third payment]
+ accrued interest] + accrued interest]
After your n payments, equation (3) generalizes, and your total remaining debt is:
n-1
= P(1+r) n - X∑ (1+ r) i (4).
i=0
That is, when all n (= 120)payments are made,
n-1
P(1+r) n = X∑ (1+ r) i (5)
i=0
n-1
Or, X = P(1+r) n / ∑ (1+ r) i (6)
i=0
= P(1+r) n / [(1+r) n – 1]/r (7 )
= rP(1+r) n / [(1+r) n – 1], which, given that P = 100,000, r = 0.01 and n = 120,
= 3300.3869/2.3003869 = $1434.7095.
Hence, your total payment is $20,000 + 120 (1434.7095) = $192,165.14, or $72,165.14 in total capital rent.
That is, the net present value (NPV) of $172,164.14 must be $100,000.
NPV(nX) = X/(1+r) + X/(1+r) 2 + X/(1+r) 3 + … + X/(1+r) n (8).
= X [ 1 – 1/(1+r) n ]/r] (9)
= $1434.7095 (69.70522) = $100,000.
59

In equation (6), to prove that the denominator of the RHS is [(1+r) n – 1]/r.
Let
K = (1+r) 0 + (1+r) 1 + (1+r) 2 + … + (1+r) n-1 (10),
= 1 + (1+r) + (1+r) 2 + … + (1+r) n-1 (11).
Then
K(1+r) = (1+r) 1 + (1+r) 2 + (1+r) 3 + … + (1+r) n (12).
Subtracting (11) from (12) yields
K(1+r) – K = rK = [(1+r) n – 1] (13).
Hence,
K = [(1+r) n – 1]/r QED.
To prove that RHS of equation (8) = RHS of equation (9) = X [1 – 1/(1+r) n ]/r.
Let
S = 1/(1+r) + 1/(1+r) 2 + 1/(1+r) 3 + … + 1/(1+r) n (14).
Then
S(1+r) = 1 + 1/(1+r) + 1/(1+r) 2 + 1/(1+r) 3 + … + 1/(1+r) n-1 (15).
Subtracting (14) from (15) yields
S(1+r) – S = 1 - 1/(1+r) n (16).
S + rS – S = rS = [1 - 1/(1+r) n ] (17).
S = [1 - 1/(1+r) n ]/r QED.
60